A Trader Journal

Change yourself, change your trading.

Sector Switching - Playing the Macro theme..

Labels: , ,
This study is NOT about Sector Rotation. Continuing our series on playing the macro themes, this research is about utilizing the "Risk On-Risk Off" (instead of business cycle) for timing the Sector investments and to tactically switch between Sectors and Long Term treasuries. I have not seen any studies on the net which approach this way when it comes to playing Sectors. 

Note: For interested readers, this study lends well for applying Sector Rotation concepts as an additional filter. If you do, please drop me an email with your observations.

Coming back, this system basically involves three parts - 
  1. Strategic selection of Sectors to cash on Macro theme
  2. Tactical Switching between Sectors and Long term Treasury Bonds.
  3. Timing the Sector Switches
For this study, the universe of available sectors to invest is S&P sector SPDRs. That doesn't mean one cannot use industry groups or a more granular sector groupings. I chose S&P Sector SPDRs primarily because of their longer price history.

Strategic Selection of Sectors - 

All sectors are NOT equally sensitive to interest rates. Same when it comes to inflationary conditions and future expectations about rates. So why not focus on those sectors that are particularly sensitive? So for this study, the shortlisted sectors are
  • Housing ............................... IYR
  • Energy  ................................ XLE
  • Basic Materials ................... XLB
  • Industrial ............................ XLI
  • Discretionary Spending ...... XLY
Now I have not done any quantitative study to actually measure the sectors sensitiveness. I chose Sectors mostly on conceptual basis. For example, low/decreasing interest rates is good for housing. On other hand, materials prices will have upward pressure in that environment.

Tactical Switching between Sectors & Treasuries -

The study uses TLT as a proxy for Long Term Treasuries. Similarly this research uses  "Equal Weighting" scheme for allocating account capital. 

Note: Interested readers might also want to explore variable weighting scheme (like volatility based weighting) for account allocation to see if that improves results further.

The switching rules between sectors and treasuries are fairly simple. Following are the rules:
  • Divide the account into 5 equal parts as per our Equal Weighting scheme. 
  • Allocate each part (i.e., 20% of the account) to one of the above selected sectors.
  • When timing rule to switch into a sector is triggered (rules given in next section), then invest the allocated part into that sector. 
  • When timing rule tells us to switch to treasuries from a sector, then move the invested amount from that sector to the treasuries. 
Timing the Sector Switches -

 For timing the sector switches, this research uses both "absolute momentum" and "relative momentum". I think we covered in one of the prior posts why it is better to consider both types of momentum. So no point in going over that again. Please drop me a comment or mail if you have any question.

Following are Timing rules to switch between a given Sector & Long term Treasuries. The rules are evaluated over the weekend: 

(Switch to Sector) 
  • Rule:1 -- Sector current week close is greater than the close 13 weeks ago AND the sector returns (percent gain) over last 13 weeks is greater than treasuries return  over the same 13 weeks. 
  •  Rule:2 -- If above rule is met, then close the Treasuries position and switch to cash in coming week. After that switch from cash to that sector in following week.
  • Note: One can theoretically switch position from Treasuries to Sector on same day but practically that is not likely. So this system assumes, there is a 1 week delay in between. Also that allows one to use discretion for getting better entries and exits. The test assumes all entry and exit prices are @ Monday Open price.
(Switch to Treasuries) 
  • Rule:1 -- TLT current week close is greater than the close 13 weeks ago AND the TLT returns (percent gain) over last 13 weeks is greater than matched sector return  over the same 13 weeks. 
  •  Rule:2 -- If above rule is met, then close the Sector position and switch to cash in coming week. After that switch from cash to TLT in following week.
Some Notes - 
  • Usual caveats...Results are frictionless i.e., no slippage or commissions. Calculations are based on closed equity. 
  • Duration: Jan 2002 - Current. (~ 11 years). Time Frame: Weekly.
  • Account Initial Capital - $100k  
  • Benchmark - SP500 Index.
Results -
Following annotated images provide various performance stats.  If the images don't convey information well then please let me know your suggestions/improvements.

 My key takeaways from the results are -
  • The concept of utilizing macro theme for sector switching and timing shows promise.
  • The images provide performance stats at both account & individual sector level. Forensics on the latter provide some pretty interesting stats. See Housing, Discretionary and Material Sectors switches. I can guess logically housing sector switch out performance but have to think bit more about Discretionary and Material sectors out performance. Any comments?
  • Low correlation of the account (as well as individual sector switches) when compared to the benchmark i.e., SP500 index. Makes it a good candidate for strategy diversification.
  • Low drawdown. Makes it a good candidate to apply "Risk Parity" approach. 




Any Thoughts? Comments? Suggestions?
Wish you all good health and good trading!

Disclaimer - 
The above study (or for that matter any thing on this blog) is NOT a recommendation. The study is not for live trading. It will need additional improvements and lot more testing before any consideration for live trading.

0 comments:

Post a Comment

Subscribe to: Post Comments (Atom)
Share