Strategy’s ‘sweet spot’ for investors

We tend to form views on the US equity market versus the Japanese equity market, versus the German equity market and so on. Or we may broaden our thinking and consider the European market versus Asian markets, or developed markets versus emerging markets. 

But geographic location is becoming less relevant when it comes to investing. Globalisation is turning the world increasingly into a single marketplace. Since the early 1970s, world trade has rocketed from around a quarter of GDP to more than 50 per cent of GDP today, according to the World Bank. It is important, therefore, to keep in mind that company shares are not de facto shares in a country. Indeed, research shows that the sector a stock is part of is a bigger indicator of potential performance than the country or region the company happens to be based in.

Professional investors have been using sector rotation strategies, which entail taking a view on the prospects for specific industry sectors, for a long time. Sector-based exchange-traded funds (ETFs) have made accessing specific sector exposures very straightforward.

The research paper ‘Sector Rotation: A multi-factor perspective’ published by Deutsche Asset Management, looked at the performance of different sectors on a global basis over time, at how diversified the performance was between sectors, and at how certain strategies rotating between different sectors could be put in place. The research examines a macroeconomic strategy, a valuation strategy, one based on fundamentals, a momentum strategy and a sentiment strategy. It finds distinct performance differences do exist between sectors and that sector rotation strategies may be able to capitalise on them. 

A macroeconomic approach assumes a relationship between sectors and the business cycle. The aim is to identify where the world is in terms of the cycle and which sectors are likely to do well in relation to this. For example, in the early part of the cycle, during the growth phase, sectors such as information technology and financials would be expected to do relatively well, and sectors like energy and utilities to not do so well on a relative basis. Later, during the recession phase, defensive sectors like healthcare would be expected to do relatively better than others, such as industrials. 

A valuation strategy typically attempts to identity the relative ‘cheapness’ or ‘richness’ of each sector based on recognised valuation approaches, such as price-to-earnings ratios. The fundamental approach tries to identify the particular strengths of each sector as measured by the growth of fundamental metrics, such as earnings growth. Momentum focuses on the absolute and relative performance of each sector in recent times – whether the sectors  are moving up or down at a faster rate than other sectors. Finally, the sentiment approach utilises analyst forecasts on each sector to position the portfolio in relation to upwards and downwards revisions to those forecasts. 

Producing an analytical framework for establishing a sector rotation portfolio is straightforward and can be done by seeking specific factors that can be used as trade signals for the strategy. For example, the 12-month forward estimated price-to-earnings ratio could be a factor in establishing the trade signal for the valuation strategy. 

One of the common metrics used to assess the merits of particular investment strategies is called the ‘hit ratio’. This relates to the historical probability of how well a factor (say flagging a relatively low valuation – when a sector is deemed ‘cheap’) should predict above-average medium-term returns. Our results show that most of the approaches have historically yielded good results, meaning they have achieved hit ratios of higher than 50 per cent. 

Sector rotation strikes an interesting sweet spot between single-stock and broad-index exposure: while representing well-diversified baskets of stocks, it also provides specific risk-profiles and differentiated exposures to macroeconomic cycles. By examining factors such as valuation or momentum, investors in sector ETFs may be able to take advantage of their different performance patterns to add value in particular market environments.

Vincent Denoiseux is head of ETF quantitative strategy at Deutsche Asset Management