Do sector and factor rotation represent a fool’s errand?

Updated: Oct 28

Investors have a natural attraction to rotation strategies.

The prospect of selling out-of-favor stocks and rebalancing to in-favor stocks before the competition is an appealing, and potentially lucrative, endeavor. Implementing a successful rotation strategy, however, relies on two crucial components, each of which requires extreme expertise. The first component is designing an indicator variable that provides an effective signal of when to rebalance the portfolio. The second component requires the investor to identify securities that accurately mirror the identified underlying shift in market conditions.

EIA’s founders designed the Invest with the Fed (IFED) strategy based on over 30 years of peer-reviewed academic research. The IFED strategy is a dynamic, rules-based strategy that has been shown to successfully navigate shifts in market conditions. The strategy’s efficacy is supported by the performance of our initial customized, large cap U.S. equity index (Nasdaq IFED-L). Nasdaq IFED-L was launched on June 9, 2020, and subsequently, two UBS ETNs tracking the index were listed on the NYSE on September 14, 2021. Nasdaq IFED-L’s performance since launch is shown in Exhibit 1.

Exhibit 1: Nasdaq IFED-L Performance Since Launch (through September 2022)

The returns in Exhibit 1 support the robustness of the IFED strategy as the strategy has outperformed over a period of very diverse events including a pandemic, dramatic supply chain disruptions, high inflation, and Russia’s invasion of Ukraine. Furthermore, the time frame includes periods witnessing both extremely accommodative Fed monetary policy and stringent tightening of policy.

Nasdaq IFED-L’s performance relative to other prominent large-cap indexes since its launch is illustrated in the two panels of Exhibit 2. The first panel shows performance since Nasdaq IFED-L’s launch, whereas the second panel shows year-to-date performance.

Exhibit 2: Nasdaq IFED-L Live Performance Relative to Other Indexes

Relative to other prominent indexes, Nasdaq IFED-L has been the best performing index over both time frames reported in Exhibit 2. This accomplishment provides strong confirmation for the robustness of the IFED strategy. Note, the first timeframe represents a period of strong market performance as it corresponds with the economy’s recovery from the worst of the Covid pandemic. In contrast, the second timeframe reflects a period of market weakness as concerns about languishing economic growth and high inflation caused a substantial market correction in 2022. The observation that the IFED strategy produces superior performance in each period supports the strategy’s efficacy. The strategy adjusts to market conditions so that portfolio composition is always appropriately aligned with the prevailing environment. Note, that the second-best performing index in the first panel, S&P 500 High Beta, is the second-worst performer in the second panel. This is not an atypical pattern for static indexes, which tend to go in- and out-of- favor as market conditions fluctuate. The dynamic nature of the IFED strategy allows it to avoid such boom-and-bust cycles.

What Makes the IFED Strategy Unique?

Unlike other strategies that rely on various economic measures, the IFED strategy relies on Federal Reserve policy signals as its indicator variable. Based on our many years of research, we contend that Fed policy signals provide superior guidance to shifts in market conditions for several reasons.

  1. Changes in Fed policy rates signal shifts in both monetary conditions and economic conditions. The Fed operates under a dual mandate whereby the Fed focuses on maintaining price stability (i.e., keeping inflation under control) and fostering full employment (i.e., promoting economic activity). Therefore, a shift in Fed policy occurs when the Fed determines that a change in policy is warranted to offset harmful developments appearing on the horizon for inflation and/or economic activity. Most rotation strategies rely on a direct measure (or measures) of economic activity to pinpoint their rotation timing. In contrast, by relying on Fed policy signals, the IFED strategy captures monetary conditions directly as well as capturing future economic activity via an indirect affiliation between Fed policy shifts and both current and future economic activity.

  2. Changes in Fed policy rates precede changes in economic variables because the Fed adjusts policy based on its forecasts, and further, changes in Fed policy rates (and interest rates in general) have ramifications for future economic activity. Therefore, the IFED strategy integrates a forward-looking aspect into the portfolio reallocation process. In contrast, other investment approaches that emphasize the business cycle and/or the level of economic activity generally rely on backward-looking measures of economic conditions.

  3. A change in Fed policy rates serves as a more effective signal of a genuine shift in market conditions. The Fed influences the availability of money, the level of interest rates, and the behavior of market participants. Furthermore, relative to most market participants, the Fed has superior access to economic and monetary information.

  4. A temporary or transitory change in an economic variable may prompt a stock reallocation in rotation strategies that rely on economic variables. In contrast, the IFED strategy avoids such false signals because the Fed avoids shifting policy if it deems a change in an economic measure to be temporary or transitory. In addition, many economic variables are measured with error and on a significantly lagged basis, which greatly reduces their reliability as indicator variables.

  5. There is compelling empirical support linking changes in Fed policy rates with subsequent stock returns. In contrast, there is limited empirical evidence establishing a significant systematic link between reported economic variables and subsequent stock returns. Additionally, EIA founder research compared the linkage between stock returns relative to business cycles versus monetary cycles. The published study found that monetary cycles maintain a far more consistent linkage even though business cycles are identified with a significant lag.

The IFED strategy also differs from other investment strategies regarding the underlying firm fundamentals that are used. The IFED approach relies on twelve firm-specific metrics that reflect a diverse set of firm characteristics, whereas most strategies employ a small and static set of financial variables. In the IFED strategy, the twelve metrics are assigned different weights in each of the market environments classified by the IFED indicator variable. We believe market conditions dictate the value of a particular firm feature. For example, holding a large cash reserve is beneficial for a firm when funds are difficult to obtain; however, large cash holdings have limited incremental value when funds are readily available in the marketplace.

Long-Term Performance of the IFED Strategy

The IFED strategy is underpinned by established patterns between Fed policy, market conditions and security returns. The founder’s research confirms that these patterns have persisted for decades. Thus, the strategy is designed as a long-term strategy and is best judged by its long-term performance. The following exhibit shows the back-tested 5-year rolling average annual alphas for IFED-A, which is an EIA U.S. equity index that starts with the 1,500 largest stocks as its investment universe. Click here to see information about EIA’s other index offerings.

Exhibit 3:IFED-A Long-term Backtested Performance

The 5-year rolling average annual alpha reported in Exhibit 3 supports the long-term consistency of outperformance for the IFED strategy. During the 23-year period from 1999 through September 2022, IFED-A’s alpha was never negative. In addition, the level of outperformance was consistently strong showing only short periods where outperformance subsided somewhat. The index rebounded substantially following each period where outperformance temporarily dipped.

Sector and Factor Attribution

The advent of exchange traded products (ETPs) that target sectors or factors has greatly facilitated the implementation of sector and factor rotation strategies. Investors can easily move funds across sectors and investment styles by trading ETPs. Once an investor adopts an indicator variable, implementing the rebalance with ETPs can be easily accomplished. However, even if one assumes the indicator variable chosen is effective, problems remain because ETPs do not differentiate across stocks. For example, a sector fund will hold a representative sample of firms from the sector without consideration of firm quality or the firm’s alignment with the current market environment. Does anyone really believe that technology firms as diverse as Meta, Cisco and Lam Research would be equally under- or over-valued for the environment identified by an indicator variable?

By relying on 12 diverse firm metrics, several of which reflect quality features of the underlying firm, the IFED strategy selects a diverse portfolio that has a broad cross section of sector and factor exposures. By adjusting each metric’s weight, the strategy ensures that each metric’s influence is appropriately matched with the prevailing market environment.

The uniqueness of the IFED strategy is confirmed by the sector and factor attribution analyses shown in Exhibit 4, Panel A (Sector Attribution) and Panel B (Factor Attribution).

Exhibit 4:IFED-A Sector and Factor Attributions

Both sector and factor attribution confirm that the majority of IFED-A’s alpha is sourced from its ability to select stocks that align with prevailing market conditions. The strategy does not maintain any consistent above average exposure to particular sectors or factors, but rather, varies exposure to a diverse set of firm features conditional on the market environment.

The IFED Strategy vs. Sector Rotation

Overall, the evidence suggests that designing an effective sector rotation strategy requires tremendous skill or a case of phenomenal luck. Therefore, we contend that sector and factor rotation do represent a fool’s errand for all but the most skilled or most fortunate of investors. For the majority of investors, the following features highlight the superiority of the IFED strategy relative to sector and factor rotation approaches.

  • The IFED strategy relies on an indicator variable that has been validated to be superior to other indicators based on over 30 years of academic research.

  • The IFED strategy uses twelve independent and diverse financial metrics to identify a portfolio of individual stocks, each of which has characteristics that are optimally aligned with prevailing market conditions.

  • IFED indexes have produced large positive alphas in long-term, back-tested performance. The superior performance of Nasdaq IFED-L since it went live on June 9, 2020, confirms the reliability of the back-tested data and the on-going merits of the IFED strategy.