Buy and hold or sector rotation?

foolProf

In long run, seems that RSI model wins, while chasing long or short low lose.

https://guidance.fidelity.com/viewpoints/buy-and-hold-sector-rotation

Buy and hold or sector rotation?

Fidelity Active Trader News — 03/26/12

A look at how sector rotation strategies may compare.

The stock market tends to trade in patterns. For example, the financial sector as measured by the Financial Select Sector SPDR ETF (XLF

	Loading..

) fell in November 2011, while the utility sector as measured by the Utilities SPDR ETF (XLU

	Loading...

) climbed modestly during the same month. Then, during January 2012, just two months later, the XLF rallied sharply and the XLU trended lower. This is intended to show that particular groups of stocks, and other assets, may broadly cycle in and out of favor with investors, depending on what is happening in the economy.

Obviously, we as investors want to have our money in those areas of the market that are expected to perform well. Since no individual sector always produces the best results, strategies that identify which part of the market are expected to perform during a specific period of time may be able to enhance portfolio management and returns. Here, we look at a Wealth-Lab Pro^® portfolio simulation to evaluate ways to scout out potential winning sectors.¹

Looking at the market through a sector lens

One primary benefit of thinking about the market in terms of sectors is that you can evaluate opportunities and make investment decisions based on bigger trends that broadly impact global economies, particular asset classes, industries, or groups. There are many ways of viewing individual parts of the market as larger groups. For the purposes of our backtest, we use the following groups:

• The SPDR^® exchange-traded funds (ETFs). These funds provide a means to trade the sectors directly using the tickers.
• The iShares^® ETFs, which groups companies of similar size together. In addition to the SPDR ETFs, we will attempt to backtest the iShares ETFs through ten years of historical data.
• The complete set of 30 iShares funds. This family includes international and bond ETFs to help capture profits across the globe.
• The Dow Jones Industrial Average (DJIA, or the “Dow”).

Sector rotation strategies

One intuitive way to employ a sector rotation strategy is to pick those with the most momentum. In our simulatons (see charts), the High RoC (high rate of change) rotation strategy attempts to do this. It invests 33.3% of the account in each of the top three components with the highest percentage gain over the past 30 days. Another alternative approach would be to employ the Low RoC (low rate of change), which picks the three lowest percentage gainers. An investor might use this latter strategy to find value in beaten-down sectors.

An attempt to capitalize on the possibility of winning stocks continuing to win and losing stocks continuing to lose is the long/short (L/S) strategy. This strategy buys into two High RoC tickers and, at the same time, shorts the lowest RoC ticker. The simulation allocates 45% to each position, with a 1.5 margin account. Commissions are included in the calculations, while margin interest, which can potentially be significant, is not.

A somewhat more complex approach involves checking the Relative Strength Index (RSI), a technical indicator used to gauge value based on past price history, to determine the choice funds. This strategy seeks the three lowest 14-day RSI values and attempts to incorporate these potential new investments by adjusting 33.3% of the fund holdings on a daily basis. It’s important to recognize that this strategy, which essentially emphasizes buying low and selling high, is particularly vulnerable to a prolonged downturn. Another bargain hunter strategy is investing in the Dogs of the Dow. These are 10 of the 30 stocks listed on the DJIA that have the highest dividend yield. This strategy puts 10% of the portfolio on each of the 10 Dow stocks.

Shortly, we will highlight how these strategies are applied in various ways to the sector funds, style funds, the commission-free iShares, and the Dow 30 stocks.

Getting a feel for performance through benchmarks

It can be helpful to understand the results of these simulations within context. You can do this by reviewing Table 1 for buy-and-hold performance, the benchmark that we compare various sector rotation strategies against. The stocks or ETFs in each group were given an equal share of the portfolio and held for a 10-year period. The hypothetical portfolio starts out with $100,000 on 12/31/2001. Wealth-Lab Pro shows idealized results of different choices over the next 10 years. Even though the simulation produces results that are different from reality, it does provide context for comparing strategies.

Table 1: Buy-and-hold comparison of sectors and stocks tested

	Column 1	Column 2	Column 3	Column 4	Column 5
Buy-and-Hold Comparison 12/31/2001– 12/31/2011	SPDRs: 9 Select Sector ETFs	iShares 9 S&P Style ETFs	iShares All 30 Fidelity Commission- Free ETFs	Dow - Equal Weight of 30 Stocks	S&P500 (IVV iShares ETF tracking fund)
Starting Capital	$100,000	$100,000	$100,000	$100,000	$100,000
Ending Capital	$160,029	$172,167	$152,798	$162,063	$130,430
Net Profit $	$60,029	$72,167	$52,798	$62,063	$30,430
Net Profit %	60.0%	72.2%	52.8%	62.1%	30.4%
Annualized Gain %	4.8%	5.6%	4.3%	5.0%	2.7%
Total Commission	($72)	$0	$0	($239)	($8)
Dividends Received	$23,684	$16,907	$21,456	$27,565	$20,377
Number of Trades	9	9	29	30	1
Win Rate	88.9%	100.0%	82.8%	60.0%	100.0%
Maximum Drawdown	($84,414)	($98,433)	($79,755)	($76,261)	($78,159)
Sharpe Ratio	0.39	0.40	0.38	0.40	0.25
Source: Wealth-Lab Pro.® For illustrative purposes only. Past performance is no guarantee of future results.

Obviously, profit is the primary benchmark of success. It is worth noting that dividends made up two-thirds of the profit for the S&P 500 during the past ten years, and just holding the style or sector funds produced better returns than the S&P 500. Our goal here is to find rotation strategies that top those results.

Other components of Table 1 include commissions (cost of making a trade), drawdown (how far the fund went in the wrong direction), and the Sharpe ratio (a measure of excess return per unit of additional risk). A higher Sharpe ratio is desired, as it indicates more return for the amount of risk that is assumed.

Let’s see the simulated performance

For the sector funds, only the Low RSI rotation strategy (displayed in Table 2, column 1), was able to produce better returns than an investor would have realized by simply holding the SPDR sector funds (as shown in Table 1, column 1). It earned an 8% annualized gain, even after paying more than $22,000 in commissions. The other strategies, when applied to the SPDR, underperformed the SPDR benchmark. In fact, the L/S strategy lost money.

Table 2: Simulated results for SPDR sectors rotation strategies for 10 years ending 1/1/2012

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6
SPDR Select Sector ETFs	SPDR Sectors RSI Rotation	SPDR Sectors Low RoC	SPDR Sectors High RoC	SPDR Sectors RoC Long/Short (L/S)	SPDR Sectors L/S: Long Trades	SPDR Sectors L/S: Short Trades
XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY	3 lowest, 33.3% each	3 with 33.3% each	3 with 33.3% each	2 long, 1 short 45% each, 1.5 margin	2 highest RoC long	1 lowest RoC short
Starting Capital	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
Ending Capital	$222,130	$156,915	$111,078	$99,847	$120,032	$79,815
Net Profit $	$122,130	$56,915	$11,078	($153)	$20,032	($20,185)
Net Profit %	122%	57%	11%	0%	20%	–20%
Annualized Gain %	8%	5%	1%	0%	2%	–2%
Total Commission	($22,220)	($2,186)	($2,282)	($2,759)	($1,765)	($994)
Dividends Received	$32,258	$25,575	$20,097	$8,498	$16,100	($7,601)
Number of Trades	1,399	139	145	175	112	63
Average Bars Held	6.34	54.03	51.83	43.12	44.88	40
Win Rate	59%	63%	56%	50%	59%	35%
Maximum Drawdown	($88,087)	($107,957)	($80,659)	($35,207)	($59,057)	($52,342)
Sharpe Ratio	0.55	0.34	0.15	0.07	0.2	–0.18
Source: Wealth-Lab Pro.® For illustrative purposes only. Past performance is no guarantee of future results.

Looking at the simulations for the iShares style ETFs, the RSI rotation strategy was the leader. The Long/Short strategy, overall, suffered due to the short trades. Breaking down the Long and Short aspects of the strategy shows that going long with the top 2% gainers was the most valuable part for the style funds.

Table 3: Simulated results for iShares S&P Style rotation strategies for 10 years ending 1/1/2012

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6
iShares Style ETFs	SPDStyles RSI Rotation	Styles Low RoC	Styles High RoC	Styles RoC Long/Short (L/S)	Styles L/S: Long Trades	Styles L/S: Short Trades
IVW,IVV,IVE,IJK, IJH,IJJ,IJT,IJR,IJS (Commission-Free at Fidelity)	3 lowest, 33.3% each	3 with 33.3% each	3 with 33.3% each	2 long, 1 short 45% each, 1.5 margin	2 highest RoC long	1 lowest RoC short
Starting Capital	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
Ending Capital	$192,428	$157,771	$176,905	$168,785	$193,989	$74,796
Net Profit $	$92,428	$57,771	$76,905	$68,785	$93,989	($25,204)
Net Profit %	92%	58%	77%	69%	94%	–25%
Annualized Gain %	7%	5%	6%	5%	7%	–3%
Total Commission	$0	$0	$0	$0	$0	$0
Dividends Received	$19,514	$25,094	$16,724	$6,194	$14,297	($8,103)
Number of Trades	1,481	105	135	155	103	52
Average Bars Held	6.04	63.71	51.83	48.55	48.71	48.25
Win Rate	58%	65%	64%	48.55%	64%	35%
Maximum Drawdown	($108,838)	($124,298)	($101,557)	($37,566)	($82,850)	($63,782)
Sharpe Ratio	0.45	0.31	0.41	0.6	0.49	–0.17
Source: Wealth-Lab Pro.® For illustrative purposes only. Past performance is no guarantee of future results.

Considering a wider variety of stock, bond, and international ETFs produced the highest historical performance, as demonstrated by Table 4.

Table 4: Simulated results for commission-free iShares rotation strategies for 10 years ending 1/1/2012

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6
All Commission-Free iShares ETFs	iShares RSI Rotation	iShares Low RoC	iShares High RoC	iShares RoC Long/Short (L/S)	iShares L/S: Long Trades	iShares L/S: Short Trades
	3 lowest, 33.3% each	3 with 33.3% each	3 with 33.3% each	2 long, 1 short 45% each, 1.5 margin	2 highest RoC long	1 lowest RoC short
Starting Capital	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
Ending Capital	$213,073	$120,846	$322,150	$228,881	$262,453	$66,429
Net Profit $	$113,073	$20,846	$222,150	$128,881	$162,453	($33,571)
Net Profit %	113%	21%	222%	129%	162%	–34%
Annualized Gain %	8%	2%	12%	9%	10%	–4%
Total Commission	$0	$0	$0	$0	$0	$0
Dividends Received	$52,438	$44,717	$43,202	$11,753	$35,313	($23,560)
Number of Trades	2,111	153	162	183	116	67
Average Bars Held	4.54	44.93	46.5	41.28	43.36	37.67
Win Rate	60%	63%	62%	51%	59%	36%
Maximum Drawdown	($103,960)	($108,494)	($67,605)	($42,615)	($57,161)	($72,523)
Sharpe Ratio	0.53	0.2	0.89	0.72	0.78	–0.16
Source: Wealth-Lab Pro.® For illustrative purposes only. Past performance is no guarantee of future results.

The momentum strategy of getting in the top 10% of the 30 commission-free iShares funds (shown in column 3) was the ideal way to approach this strategy. See Figure 1 for a graphic depiction of the Equity Curve, compared to Buy and Hold of IVV—the S&P 500 ETF by iShares.

Figure 1—Simulated Equity Curve for RoC High strategy applied to iShares ETFs vs. Buy and Hold of IVV

Splitting investment capital between the top two High RoC iShares ETFs produced a nice gain as well. Shorting the lowest RoC just cost money when dealing with this group.

Also of note, RSI Rotation among the 30 iShares ETFs produced substantial gains, but came with larger drawdown than the High RoC momentum rotations.

Dow 30 stock strategies

Shifting to Dow stocks, the simulation showed that the RSI rotation strategy tested out as the most profitable of the whole field, although there was a large drawdown. Neither choosing the High RoC stocks nor the Low RoC stocks, generated a profit.

Figure 2—RSI Rotation of current Dow 30 plotted versus Buy and Hold of BAC—Wealth-Lab Pro portfolio simulation

Figure 3—Monthly Profit/Loss of Dow 30 RSI Rotation—Wealth-Lab Pro Portfolio Simulation

Focusing on risk and reward

Risk is an extremely important consideration for investors. In order to have seen the results depicted in these simulations, the investor would have needed to be able to stick with the strategy over the long term. This may not always be possible due to individual differences in risk tolerance and acceptable drawdown levels. When looking at Sharpe ratios, the top three performers in our simulation were:

• iShares 30 RoC High (Table 4, column 3).
• iShares Styles RoC High: only the long part of the Long/Short strategy, i.e., the top two RoC ETFs. (Table 3, column 5).
• Dow 30 RSI rotation strategy (Table 5, column 2).

Table 5: Simulated results for Dow 30 rotation strategies for 10 years ending 1/1/2012

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6	Column 7
Dow 30–10 yr	Dogs of Dow 10 yr	RSI 10 yr	RoC Low 10 yr	RoC High 10 yr	Long/Short 10 yr	Long Trades	Short Trades 10 yr
Starting Capital	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
Ending Capital	$218,066	$345,147	$127,184	$56,847	$74,604	$82,422	$92,182
Net Profit $	$118,066	$245,147	$27,184	($43,153)	($25,396)	($17,578)	($7,818)
Net Profit %	118%	245%	27%	–43%	–25%	–18%	–8%
Annualized Gain %	8%	13%	2%	–5%	–3%	–2%	–1%
Total Commission	($541)	($32,126)	($2,934)	($3,156)	($3,156)	($2,115)	($1,041)
Dividends Received	$36,468	$39,059	$31,293	$20,271	$10,969	$19,982	($9,014)
Number of Trades	36	2,022	186	200	200	134	66
Average Bars Held	252.78	4.69	40.63	37.86	37.86	37.67	38.23
Win Rate	56%	61%	54%	48%	48%	49%	45%
Maximum Drawdown	($130,332)	($153,644)	($121,503)	($91,696)	($82,881)	($95,722)	($64,602)
Sharpe Ratio	0.44	0.66	0.23	–0.14	-0.02	0	0.05
Source: Wealth-Lab Pro.® For illustrative purposes only. Past performance is no guarantee of future results.

A way to decide between these options is to see which is the most resilient to different circumstances. After all, these are simply simulations based on the past, and we don’t know what will influence these funds or strategies in the future.

Table 6: Simulated results for Dow 30 rotation strategies for five years ending 1/1/2012

	Column 1	Column 2	Column 3	Column 4
Dow 30—5 yr.	Dogs—5yr.	RSI—5 yr.	Hi PE—5 yr.	Lo PE—5 yr.
Starting Capital	$100,000	$100,000	$100,000	$100,000
Ending Capital	$100,400	$192,182	$173,370	$145,898
Net Profit $	$400	$92,182	$73,370	$45,898
Net Profit %	0%	92%	73%	46%
Annualized Gain %	0%	12%	10%	7%
Total Commission	($716)	($18,945)	($1,057)	($660)
Dividends Received	$15,064	$17,114	$21,937	$20,933
Number of Trades	50	1,193	68	43
Average Bars Held	252.8	4.72	64	100.63
Win Rate	50%	60%	53%	53%
Maximum Drawdown	($66,770)	($88,643)	($73,758)	($58,925)
Sharpe Ratio	0.1	0.57	0.56	0.4
Source: Wealth-Lab Pro.® For illustrative purposes only. Past performance is no guarantee of future results.

Since the RoC High strategy only evaluates the choices once a month, the optimization feature of Wealth-Lab Pro can show how the results vary, depending on which day of the month is chosen (See Figures 4 and 5).

Figure 4—Wealth Lab simulation of top three iShares 30 High RoC, with various evaluation dates

Consistency is a good quality to look for. Figure 5 shows how rotating between the 30 iShares funds produce very mixed results. That shows a distinct lack of consistency.

Figure 5—Wealth Lab simulation of top two iShares Styles High RoC with various evaluation dates

The RSI rotation strategy doesn’t have the weakness of depending on the day chosen for assessment, because it evaluates the investment choices each day. It does have a much larger drawdown, and as a result, a lower Sharpe ratio. The RSI rotation strategy may be harder to implement because it requires charting tools to calculate the RSI values, whereas the monthly performance of stocks and ETFs is generally simpler to set up and see.

The Dow 30 stocks, with RSI rotation strategy, produced greater profits, but these types of results may prove difficult to replicate. One reason is that you would have to know if and when a Dow component would be replaced from the index.

Investing implications

Most of the strategies tested here came in significantly ahead of buy and holding the S&P 500. Of course, these results are not representative of every sector rotation strategy, and results may differ depending on the underlying assumptions and other qualifying factors that could have been used. But based on this simulation, rotating among high-quality segments of the market may produce very positive results that can beat the buy-and-hold strategy. Ultimately, it is up to you to decide whether these strategies meet your investing objectives and risk tolerance.

silicon_beaver

Time to mine individual stock.

bububaba

redflag

rightonmoney