Tweaking the Sector Rotation Strategy (Part 1)
In the next two posts I’ll test some tweaks to the Fidelity Select sector rotation strategy that we introduced last week.
Side note: turns out Woodshedder did a series on the same starting strategy back in January. I’m NOT going to dig into Wood’s work just yet. It should be interesting to see if we both came out in the same place.
The graph above shows the results of the original strategy (light red) and a modified strategy (dark red), versus the Vanguard S&P 500 fund VFINX (grey), since 1987.
Geek notes: (a) in my last post I used the S&P 500 price index as my benchmark, but VFINX (an actual investable asset) really is a better choice, and (b) to reward the strategy for time spent out of the market, I’ve assumed a return on cash of half the interest rate composite.
The first two tweaks to the strategy are related to the two issues I raised in my original post: (a) the original strategy tended to pick volatile sectors rather than ones that were showing momentum relative to volatility, and (b) there wasn’t a mechanism to sidestep bear markets.
To combat the first issue, rather than buying the sector fund with the highest % gain over the previous 25 days, here we’re buying the one with the highest average daily % return divided by standard deviation of daily returns. Now, less volatile sectors have a chance to get in the game.
And second, we’re not initiating a position until the 50-day (simple) moving average of VFINX is above the 200-day (read more about the Golden Cross). If the 50-day falls under the 200-day while a position is already on, we still hold the position until at least 30 calendar days have passed (to get past the minimum holding period).
This is trend-following at its simplest. In real-life I would recommend a more nuanced approach (like we take with the State of the Market report) where multiple long-term averages are examined and the signals averaged (so that you could be long say 25% or 50%, not necessarily just 0% or 100%).
Numbers for the number-lovers…
This is fast becoming a worthwhile trading approach. Changing the way in which sectors were selected and adding a mechanism for sidestepping bear markets significantly reduced portfolio volatility and drawdowns and increased risk-adjusted returns.
That’s all for this first round of tweaks. In our next post I’ll try to further refine and improve our little sector rotation strategy.
[Edit: click for a summary of posts related to this simple sector rotation strategy]
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Filed under: Stock Market Sectors, Trading Strategies | 26 Comments