Monday, April 25, 2011

Sector Rotation in Practice

Sector rotation, as defined by Investopedia, is the act of moving assets from one sector of the economy to another in hopes of profiting from the economic cycle. The 10 sectors of the S&P 500 are usually broken down into three categories: Early Cycle, Late Cycle and Non-Cyclical. Each category tends to perform better during different phases of the economic cycle and sector rotation strategies attempt to capture the relative performance moves.

The chart below shows the sector rotation of U.S. equity positions held in Pinnacle’s Dynamic Moderate Growth model from 1/31/07 to present. The green line represents the allocation to non-cyclical sectors, the red line represents the allocation to early cycle sectors, the blue line represents the allocation to late cycle sectors, and the grey shading represents the recession of ’08 and ’09. We built a large position in non-cyclical sectors heading into the recession as we forecast an end of that cycle. However, halfway through the recession we started to sell non-cyclical sectors to purchase early cycle sectors as we anticipated an end of the recession and the start of the next growth cycle. Additionally, by the end of the recession our portfolios held more early and late cycle stocks as the economic recovery got underway.

By overweighting non-cyclical stocks entering the recession and overweighting cyclical stocks exiting the recession, we were able to capture the relative outperformance of certain sectors at different parts of the cycle. This is a big part of the investment philosophy here at Pinnacle and we’ve used sector rotation to create significant alpha. Alpha is a measure of risk adjusted returns over a benchmark, and we have delivered very strong risk adjusted returns since inception of our models.