Ebook Sector Rotation over Business-Cycles
A sector rotation strategy is based on the idea that certain sectors provide relative strength during different phases of the business-cycle. While rotating sectors across business cycles is not a new strategy, sector rotation has witnessed a large growth in popularity as evidenced by the increasing number of sector funds introduced over the last two decades. One group of funds alone, Fidelity Select, currently offers investors a choice of 51 sector funds. The growth of sector funds has ballooned in recent years particularly with the introduction of exchange traded funds (ETFs). In 2006, the number of sector ETFs available doubled from 67 to 135. Despite growing interest in sector investing, sector rotation investors remain reliant on conventional market wisdom and anecdotal evidence for validation of the widely held view that rotating sectors across business-cycles outperforms a simple buy-and-hold-strategy. To be sure, the notion of predictable sector outperformance reoccurring at certain periods of a business-cycle is questionable from a market efficiency perspective.
This study investigates if a sector rotation strategy guided by conventional market wisdom on the sectors to hold across business-cycles generates additional alpha returns. Given the sizable amount of investment capital sector rotation attracts, we believe that documenting whether or not sector rotation consistently provides risk-adjusted out performance will be of broad interest to both professional and private investors. Additionally, evidence of a systematic and predictable connection between sector returns and business-cycle movements would indicate anomalous market behavior and be of potential interest to financial researchers.
The results of our study indicate sector rotation does not generate risk-adjusted returns in excess of the market. We cover the period 1948-2006 with NBER defined phases of expansion and recession divided into smaller sub-periods to coincide with business-cycle stages where the market expects optimal sector performance. We find that a sector rotation investor guided by conventional market wisdom and with 20/20 hindsight timing business-cycles stages would have only realized a marginal 2.1% Jensen’s alpha. This marginal outperformance is a best case scenario that comes before any allowance for transaction fees and with the benefit of perfect hindsight. More realistically, it would seem extremely difficult for a real-time investor to correctly time sector investments across all business-cycle stages as required to systematically outperform the market.
As an alternative to sector rotation, we also consider a much simpler market timing strategy that is continually invested in the market excluding the first half of a recession. Market-timing investors would only need to anticipate one stage of the business-cycle and incur only one-fifth the transaction costs of a sector rotation strategy. For the same 1948-2006 period, a market-timing investor would have realized a slightly higher terminal wealth and higher Sharpe ratio compared to a sector rotation investor. This comparison illustrates that sector rotation would not be the optimal strategy, even for an investor with the ability to correctly anticipate business-cycle conditions. We conclude that, contrary to conventional market wisdom, rotating sectors over business-cycles is not an optimal investment strategy and question the widespread acceptance of sector rotation as a strategy that provides investors with relative outperformance.
Our contribution to the literature is twofold. First, we believe our study is the first to empirically document the performance and relative strength of sectors over the course of a business-cycle. We find actual sector performance largely fails to align with the expectations of conventional market wisdom. Secondly and more critically, we show that contrary to conventional wisdom and despite the popularity of sector rotation among investors, a sector rotation strategy yields only marginal outperformance that is inferior to a much simpler market-timing strategy.
Our study is organized as follows. Section II provides an overview and discusses the relevant literature. Section III describes business-cycles. Section IV examines the performance of sectors over business-cycles. Sector V documents the performance of a sector rotation strategy with terminal wealth estimations. Lastly, section VI concludes our analysis.
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