An Illustrative Sector Rotation RMI Strategy
To illustrate an MA-based RMI strategy, we subdivided the domestic large-cap equity universe into the ten Global Industry Classification Standard (GICS) industry sectors that are tracked by the S&P 500 sector indexes. We optimized the strategy’s parameters separately for each sector. This sectorization allows us, when we receive an exit signal for a particular sector, to redeploy the proceeds into the remaining sectors and thereby remain fully invested (at least until a critically large number of sectors “turn off,” at which point we would begin moving incrementally to cash). In the absence of buy and sell signals, sector allocation was kept stable by periodic re-balancing to the target weights of the sectors.
This strategy can be implemented using exchange traded funds (ETFs) as an effective way to gain sector exposure. Sector ETFs provide immediate diversification across stocks within the sector, thereby reducing the idiosyncratic risks of investing in individual stocks. These ETFs allow you to capture trends efficiently without the worry of selecting stocks in each sector.
It is important to note that a momentum-based strategy is “trend following.” It does not attempt to predict turning points; it strives to identify trends as early as possible in their development, and to suggest appropriate action. The overall objective of our illustrative sector rotation RMI strategy is to mitigate losses during protracted equity market downturns and to fully participate in the market otherwise. It is not designed to outperform the equity market when the market is doing well. As documented in our earlier piece on Alpha Generation through Risk-Managed Investing, this approach has the potential to significantly outperform market indexes over full bull/bear market cycles.
An illustration of the strategy on a pro forma basis is shown below, compared to the S&P 500 Total return Index. Both indexes are gross of expenses.
Of particular note is the strategy’s performance during the 2000-2002 bear market when it actually experienced a healthy increase. Since the market’s decline was largely due to a single sector (technology), the sector rotation strategy was able to withdraw early from that sector and redeploy funds to other sectors that performed well. Note also that the only significant decline for the strategy, during late 2008/early 2009, is less than half the percentage decline in the S&P 500 over that period (as can be seen clearly in the log scale version of the above graph). The strategy was less effective at minimizing losses during this period than during 2000-2002 because the 2008-2009 decline happened quite suddenly whereas in 2000-2002 it occurred over a protracted period, thereby giving the momentum signals ample time to react. To more fully protect portfolios against declines of all types, including sudden market crashes such as in 2008-2009, we believe this strategy should be supplemented by one specifically designed for crash protection, i.e., “tail risk hedging,” which we will take up in our next installment.
This material is for informational purposes only. Nothing in this material is intended to constitute legal, tax, or investment advice. Investing involves risk including potential loss of principal.
Giralda Advisors, located in New York City, is an asset management firm that focuses on providing risk-managed exposure to the equity markets with a goal of limiting asset depreciation during both protracted and catastrophic market downturns while allowing substantial asset appreciation in up-trending markets. The Giralda Advisors team welcomes your inquiries. Call (212) 235-6801 or visit us at http://www.giraldaadvisors.com/.