Wednesday, 3 October 2007

Sector rotation: an investment dead end?

Two chapters in Behavioural Investing suggest that investors focusing on sectors rather than stocks are barking up the wrong tree. Chapter 32 outlines the evidence showing that value and momentum effects are much greater at the stock (and even country level) than they are at the sector level. It also cautions that sectors are rarely stable entities in terms of their investment characteristics. Pretty much every sector has been 'vale' and 'growth' or it's lifespan. So ruling out sectors because they are growth or value is a big mistake.

Chapter 19 also touches on sectors. This presents some of the work of Cremers and Petajisto who show that those fund managers with low active share, but high tracking error (those taking sector bets) manage to destroy value for clients (having a negative gross and net alpha). Such managers account for around 35% of the US market! Whilst this isn't proof that sector rotation strategies are hopeless (that would be to confuse the absence of evidence with evidence of the absence), it does at least make one stop and think about the role of sectors.


A new paper sheds further light on the fruitlessness of trying to rotate sectors. The paper provides evidence of the absence! Stangl, Jacobsen and Visaltanachoti explore the possibility of timing sector rotation across the stages of the business cycle. They identify five stages of the cycle shown in the diagram below.


They follow a rotation strategy that seems to me to capture the conventional wisedom regarding sector rotation, as set out below.

They investigate the US market from 1948 to 2006. In a heroic leap of faith, they assume perfect foresight on the part of investors. That is to say, they assume that investors know with absolute certainty which phase of the business cycle they are in.

Even assuming such prescient powers, the sector rotation strategy only outperforms by around 2% p.a. If one were to include transaction costs, and drop the perfect foresight assumption then this would quickly become a zero, or even negative, alpha.

When one examines the detail of the sector rotation strategy, some further issues are created. For instance, those sectors favoured by the conventional wisdom in early and middle stages of expansion actually have negative alpha over those phases!

Those sectors favoured in the late expansion did outperform, but were beaten by sectors whose attractions are usually assocaited with late stage contraction! In fact, it was only really in the late stage contraction where the conventional wisdom over sector selection was the best strategy.

Stangl et al show that even if you can forecast the business cycle with complete accuracy (see my earlier post on why we don't need economists for my thoughts on this) then following the conventional wisdom with regard to sector selection is an suboptimal investment decision. You would be better off following a simple market timing model which stayed long equities apart from during the early recession period.

So sector rotation (at least as represented by the conventional wisdom viewpoint) is not a good source of outperformance. This certainly calls into question the raison d'ete of many strategists!
In fact, all of the evidence mentioned in this post raises challenges to the way in which investment is done. Not only is sector rotation highly dubious, the fact that useful investment characteristics such as value and momentum are better defined at the stock level rather than the industry level brings the role of sector specialists into doubt. I have long argued that what we need is a few analysts with good investment skills, rather an armies of industry 'experts'.

29 comments:

Bill aka NO DooDahs! said...

The sector paper has at least two issues. First, SECTORS? Gimmeafrickinbreak. To get component momo right, the components have to be small enough to be really moving relative to the index. Second, CONVENTIONAL WISDOM? Puhlease. Maybe the flaw is the CW that certain sectors have this or that performance in certain phases of the "business cycle" or that all cycles are alike, etc. Another shining example of how many papers have to be gone through in order to glean one or two gems worth knowing …

tune.rider said...

I would like to disagree with your statement that most of the price momentum is displayed at stock and/or country level. A paper by Moskowitz and Grinblatt ("Do Industries Explain Momentum?" JF, 1999) shows that, in fact, most of the individual stock momentum is explained by industry momentum. And while industries represent somewhat finer division of the stock market than sectors, the paper does provide a very strong counter-argument to your point.

James said...

I'm not sure how strong the Moskowitz and Greenblatt findings really are. A couple of recent papers have found somewhat differing conclusions. For example : http://papers.ssrn.com/sol3/papers.cfm?abstract_id=301533
and
http://www.cfapubs.org/doi/abs/10.2469/faj.v56.n4.2372
Plus in the mentioned chapters of behavioural investing I show that momentum is better defined at the stock level.
Cheers
James

Mats said...

”[…] I know of no really rich sector rotator. Maybe some people can do it. I’m not saying they cant’t. All I know is that all the people I know who got rich – and I know a lot of them – did not do it that way”/Charlie Munger

Anonymous said...

There is the theory and there is the practice. Have you heard of Ken Heebner and his CGM Focus Fund (CGMFX)? He does aggressive sector rotation, with a concentrated style. His record is pretty impressive.

tune.rider said...

James:

not to appear a stickler for details, but the O'Neal (FAJ, 2000) reference that you mention (http://www.cfapubs.org/doi/abs/10.2469/faj.v56.n4.2372)
supports my point of view.

Point taken on the first reference (SSRN) that you mention regarding the European stocks.

James said...

Tune rider,

It only supports your views if you want more risk than the index. So effectively in risk adjusted terms sector rotation adds nothing.
Cheers

James

Anonymous said...

Isn't it common "wisdom" that stocks lead sectors , sectors lead market ? I totally disagree with the viewpoint that sector rotation is a loosing game . i.e. IBD , WSJ all focus on sectors and their performance . I personally use Point and figure charts watching sectors . They decide time to enter sector , and the stocks therein . Still , to me the best performance has been picking strongest stocks in strongest alpha sectors .

Anonymous said...

"I have long argued that what we need is a few analysts with good investment skills, rather an armies of industry 'experts'."

What you describe is SAC or any of several outstanding hedge funds with good long-term track records. Shops where trading skill is valued as highly (and perhaps higher, since marktets can be irrational) as industry analysis skills. There is the industry and there is the stock of a company in that industry and the two things should NEVER be confused.

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