US Sectors Strategy

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US Sectors Strategy 2017-04-19T14:42:46+00:00

Project Description

The U.S. sector meta-strategy allocates dynamically between 4 different long US sector strategies and one short US sector strategy.

Due to the low correlation of these strategies, the combination creates a strategy with considerably higher Sharpe values. The addition of the negatively correlated short strategy significantly reduces volatility and drawdowns during difficult market periods.

The result is a meta-strategy which performed well since 2000 in the backtests. The strategy produced an average yearly profit of 12.8% (SPY 5.1%) and a Sharpe ratio of 1.16 (SPY 0.25). Maximum drawdown was only 17% (SPY 55%). So, the strategy performed about 4x better than the S&P500.

What makes this strategy interesting is that it does not rely on either treasuries or bonds to balance out and hedge in times of market stress. it uses the short US sector strategy instead. The hedging mechanism is purely “short equity” and unrelated to whether interest rates rise, a common concern when holding bonds in a portfolio.

A meta-strategy is a strategy composed not of ETFs but of sub-strategies. QuantTrader saves the performance of a strategy like an ETF. This way you can build a new U.S. Sector meta-strategy which is composed by our 5 previously discussed strategies.

Research is undertaken to ensure that the diversified mix of asset classes is appropriate for the desired level of risk. Specific ETFs are screened and chosen to best represent the asset class, while also maintaining low management fees and index tracking error.

For our strategy, we use the SPDR sector ETFs, but you can replace these sectors without any problem with the corresponding ETFs or Futures of other issuers. Here are the 10 main US industry sectors currently available with sector ETFs from SPDR:

Sector ETF
XLB U.S. Materials Sector
XLE U.S. Energy Sector
XLF U.S. Financial Sector
XLI U.S. Industrials Sector
XLK U.S. Technology Sector
XLP U.S. Consumer Staples Sector
XLRE U.S. Real Estate Sector
XLU U.S. Utilities Sector
XLV U.S. Health Care Sector
XLY U.S. Consumer Discret. Sector

Risk and Performance Profile

Risk Score:?
Performance:
3 Months12 MonthsSince Inception
Return
CAGR
Volatility
DrawDown
Sharpe
Annual Performance vs. Benchmark

The Logical Invest long-short US Sector Strategy

(A US sector meta strategy combining dynamically 5 different sector strategies)

The following paper will explain how to build a U.S. sector meta-strategy which allocates dynamically between 4 different long US sector strategies and one short US sector strategy.

Due to low correlation of these strategies, the combination creates a strategy with considerably higher Sharpe values. The addition of the negatively correlated short strategy significantly reduces volatility and drawdowns during difficult market periods.

The chart shows the portfolio performance (black) compared with the S&P500 index (SPY – red).

The result is a meta-strategy which performed well since 2000 in the backtests. The strategy produced an average yearly profit of 12.8% (SPY 5.1%) and a Sharpe ratio of 1.16 (SPY 0.25). Maximum drawdown was only 17% (SPY 55%). So, the strategy performed about 4x better than the S&P500.

What makes this strategy interesting is that it does not rely on either treasuries or bonds to balance out and hedge in times of market stress. it uses the short US sector strategy instead. The hedging mechanism is purely “short equity” and unrelated to whether interest rates rise, a common concern when holding bonds in a portfolio.

The US Sector ETF’s

U.S. sectors ETFs, based on the Dow Jones U.S. Industry Indices, have been within the first ETFs on the U.S. market. There are sector ETFs available from SPDR, Vanguard, Schwab, iShares. There are also European versions of these sector ETFs as well. These 10 Dow Jones U.S. Industry sectors cover about 95% of the US market. Their respective ETFs are highly liquid with small spreads which makes them excellent instruments to build dynamically rebalanced investment strategies.

For our strategy, we use the SPDR sector ETFs, but you can replace these sectors without any problem with the corresponding ETFs or Futures of other issuers.

Here are the 10 main US industry sectors currently available with sector ETFs from SPDR and the corresponding inverse (short) sector ETFs with leverage.

SectorSector SPDR ETFInverse Sector SPDR ETF (leverage)Sector Futures (GLOBEX)
U.S. Materials SectorXLB ETFSMN ETF(-2x)IXB Future
U.S. Energy SectorXLE ETFERY ETF(-3x)IXE Future
U.S. Financial SectorXLF ETFSKF ETF(-2x)IXM Future
U.S. Industrials SectorXLI ETFSIJ ETF(-2x)IXI Future
U.S. Technology SectorXLK ETFREW ETF(-2x)IXT Future
U.S. Consumer Staples SectorXLP ETFSZK ETF(-2x)IXR Future
U.S. Real Estate SectorXLRE ETFSRS ETF(-2x)
U.S. Utilities SectorXLU ETFSDP ETF(-2x)IXU Future
U.S. Health Care SectorXLV ETFRXD ETF(-2x)IXV Future
U.S. Consumer Discret. SectorXLY ETFSCC ETF(-2x)IXY Future

The SPDR sector ETFs exist since 1999. Only the XLRE real estate sector was added later in 2015. With the 9 main sector ETFs in existence for nearly 18 years, we can easily perform long-term strategy backtests covering all sorts of economic events, including some important market corrections in 2000, 2008 and 2011.

Due to the small spread of these ETFs and low fees with good discount brokers we can rebalance our investment monthly at low cost.

For all 10 sectors, we also have inverse sector ETFs. This allows us to short the worst performing sectors. If you use the inverse ETFs, then you have to take into account the leverage of these ETFs and divide your buy orders by 2x or 3x. If you invest using the sector futures, then shorting is no problem at all, however due to the size of the futures which is always around 100’000$ each, you should invest at least 500’000$ in such a strategy to be able to more or less achieve the requested allocations.

Most of our Logical Invest strategies are trend following strategies. This means that we follow longer economic cycles and try to outperform the S&P 500 index by rotating always on a selection of the best performing sector ETFs while avoiding the underperforming sectors.

US sectors are a very good way to do trend following, because each sector normally over- or under-performs for long periods at a time. This also means that over- or under-performance is due to longer lasting economic cycles, not just short term market fluctuations.

The economy itself is not a linear stable system, but swings between periods of expansion (growth) and contraction (recession). This results in a series of “market cycles” which are visualized in the following picture.

Source: http://www.nowandfutures.com (Global Business Cycles)

Each market cycle favors different industry sectors, and the goal of a good working strategy is to invest always in the best performing sectors while avoiding or even shorting the worst performing sectors.

An overview of different US sector strategies.

In fact there is not only one single trend following strategy possible, but we have different ways to construct sector strategies. To backtest these strategies we use our QuantTrader software.

For further details on this strategy please read the whitepaper and blog post.