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