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How one can Enhance ETF Sector Momentum
On this article, we discover the historic efficiency of sector momentum methods and look at how their alpha has diminished over time. By analyzing the underlying causes behind this decline, we establish key components contributing to the underperformance. Most significantly, we introduce an enhanced method to sector momentum, demonstrating how this resolution considerably improves the efficiency of an ETF sector momentum technique, making it as soon as once more an efficient instrument for systematic buyers.
Introduction
Sector momentum is an funding technique that goals to capitalize on the continued efficiency of particular market sectors by specializing in these with current robust returns, below the belief that this momentum will persist. On this article, we discover sector momentum particularly inside the context of ETFs. We now have beforehand examined comparable methods in Sector Momentum – Rotational System and Business Momentum – Driving Business Bubbles, the place we targeting long-only methods. Whereas the alpha of the sector momentum methods was attention-grabbing previously, the excessive correlation between sectors and elevated market effectivity that got here with the introduction of ETFs as funding automobiles diminished the efficiency of the normal long-short sector momentum. We addressed the same problem in Robustness Testing of Nation and Asset ETF Momentum Methods. Our objective on this research is to enhance sector momentum methods, whether or not by long-short or long-only approaches, aiming to boost general efficiency regardless of these difficulties. We addressed the same problem of bettering momentum methods for commodities in How one can Enhance Commodity Momentum Utilizing Intra-Market Correlation article.
On this research, we utilise a dataset comprising the 9 sectors of the S&P 500 index (ETFs) for all analyses. These sectors embody XLB (supplies), XLE (power), XLF (financials), XLI (industrials), XLK (expertise), XLP (shopper staples), XLU (utilities), XLV (well being care), XLY (shopper discretionary). All of those ETFs are adjusted for dividends and splits, which means that historic costs have been modified to mirror dividend payouts and inventory splits. This adjustment supplies a extra correct illustration of the ETF’s efficiency over time by accounting for whole returns, together with reinvested dividends, and by correcting for worth modifications on account of splits. Utilizing these adjusted costs is essential for exact historic efficiency evaluation and technique comparability. The info have been sourced from Yahoo Finance and signify the every day adjusted closing costs of the given ETF, masking the interval from December 22, 1998 to September 5, 2024.
Moreover, it’s essential to make clear that on this research, the notation “S&P 500” refers back to the SPY ETF (SPDR S&P 500 ETF Belief), which can be adjusted for dividends and splits. This exchange-traded fund replicates the efficiency of the S&P 500 index, whereas the changes account for dividends and shares splits. We use this knowledge as a benchmark for comparability.
In each desk perf stands for yearly efficiency (return), st dev represents yearly commonplace deviation, max dd means maximal drawdown, Sharpe ratio is calculated as a return to a volatility and Calmar ratio as a unfavourable return to a maximal drawdown.
On this analysis, we calculate the momentum of the ETFs primarily based on the adjusted month-to-month costs of every particular person ETF. For every month, we type all 9 ETF momentum values from highest to lowest. We then choose an elective variety of ETFs to go brief (these with lowest momentum worth) and an elective quantity to go lengthy (these with the best momentum worth).
Step 1 – Benchmark
In step one we give attention to two benchmarks for our analysis for comparability of effectiveness of the next examined methods. For this objective, we created an equally-weighted (EW) benchmark consisting of all 9 ETFs, month-to-month rebalanced, and than we in contrast it to the S&P 500 index.
The graph in Determine 1 clearly demonstrates that the equally weighted (EW) benchmark outperforms the S&P 500 index over the interval from 1999 to 2023. The effectiveness of the EW benchmark is additional supported by the Sharpe ratio and Calmar ratio offered in Desk 1.
Step 2 – Lengthy/brief momentum technique
Secondly, we needed to evaluate how efficient lengthy/brief momentum methods might be on S&P 500 sectors. We chosen 3 worst ETFs to go brief and three greatest to go lengthy, primarily based on their momentum. For this evaluation, we are going to contemplate a 12-month momentum rating interval and 1-month holding interval.
The three lengthy/3 brief momentum technique has proven poor efficiency, characterised by unfavourable returns and excessive drawdowns, leading to unfavorable ratios values. The curve of the graph reveals an unstable evolution with a declinig tendency, reflecting inefficiency. The one optimistic facet of this technique is the seen optimistic efficiency throughout market disaster, which point out some hedging properties.
Moreover, we step by step adjusted the rating interval, starting from 1 month to 12 months, and diverse the variety of belongings on lengthy/brief sides (4v4, 3v3, 2v2, 1v1). Sadly, these modifications didn’t yield any useful outcomes.
Step 3 – Separation of the lengthy/brief momentum legs
Subsequent, we determined to separate the lengthy/brief momentum right into a long-only momentum technique and a short-only momentum technique.
Lengthy-only momentum technique
After we centered on long-only technique, we determined to set 12-month rating interval for momentum (and 1-month holding/rebalancing interval), as it’s a extensively used interval in most tutorial papers. We utilized this rating interval in each technique case, deciding on 1 sector with the perfect month-to-month momentum (1 Lengthy), 2 sectors with the perfect momentum (2 Lengthy), and continued this course of till we chosen 6 sectors with the perfect momentum (6 Lengthy).
Contemplating primarily the Sharpe ratio outcomes, long-only momentum technique reveals promising potential, particularly when deciding on 4 or extra sectors to go lengthy.
Brief-only momentum technique
Just like the long-only technique, we additionally set 12-months rating interval and choose 1 (1 Brief), 2 (2 Brief), …, as much as 6 (6 Brief) sectors to go brief, primarily based on the worst month-to-month momentum, after which calculate their efficiency traits.
Based mostly on the efficiency outcomes of every technique, we are able to conclude that the technique involving the 1 worst momentum sector yields the perfect outcomes, though they’re nonetheless unfavourable. Nonetheless, the shocking truth is that short-only momentum technique that selects 1 ETF doesn’t have as unfavourable return as different variants, as a result of -7% efficiency is considerably higher than -10% efficiency.
Then, we had a spark of inspiration—what if we used an asymmetrical long-short momentum technique that picks totally different numbers of belongings within the lengthy leg than within the brief leg? And what if the short-leg (hedging leg) didn’t have the identical weight because the lengthy leg? We don’t have to hedge 100% of the lengthy momentum leg by brief momentum leg—it could be sufficient to brief just a bit and enhance the efficiency of the general long-short momentum by reducing the beta publicity of the lengthy leg by hedging with (comparatively) low-cost brief leg.
Subsequently, the conclusion is that the long-only momentum technique is more practical when it contains 4, 5, or 6 sectors, whereas the short-only momentum technique achieves probably the most appropriate outcomes by using only one sector. Plus, we are going to analyze methods that don’t brief the identical share of the portfolio as they go lengthy.
Step 4 – Mixture of the momentum and brief technique
Contemplating the outcomes of the long-only and short-only momentum methods (launched within the Step 3), we determined to mix the long-only technique with a selective hedge, the place the short-strategy isn’t set with 100% weight, however solely 5% to 30%. Whereas working with this technique, it’s essential to preserve the shorting prices in thoughts. We assume they’re roughly on the stage of the 3-month rate of interest.
We determined to implement a momentum + brief technique, using 4, 5, or 6 sectors within the lengthy momentum technique whereas shorting 1 sector. For this asset, we initially set a weight of 5%, then elevated it to 10%, adopted by 15%, and continued till we reached 30%. All through this evaluation, we maintained a 12-month rating interval (and 1-month rebalancing interval).
By evaluating the outcomes from Tables 5, 6, and seven with these in Desk 1 offered in Step 1, we are able to conclude that the momentum + brief methods are more practical than the S&P 500 or equally weighted benchmark. Subsequently, their utility is useful for buyers, particularly the 5-sectors momentum technique.
On this step, we adjusted the shorting facet of the technique, specializing in selective shorting. Sustaining a brief place all through the whole funding interval isn’t obligatory. As a substitute, we aimed to carry the brief place solely when the equally weighted (EW) benchmark (launched in Step 1) was in a unfavourable development – particularly, under the 12-month shifting common.
As within the earlier step, we chosen 4, 5, and 6 sectors with the perfect month-to-month momentum for the long-momentum half. For the short-momentum half, we used 1 sector with the worst month-to-month momentum, making use of diverse weight settings from 5% to 30% in 5% increments, however solely when the EW benchmark confirmed a unfavourable development. The 12-month rating interval stays unchanged.
At first look, it’s evident that our long-short momentum technique and the S&P 500 index exhibit very comparable conduct available in the market, albeit with totally different progress intensities. Our technique has yielded noticeably greater values, demonstrating a bent to develop and outperform the benchmark from 2001 till the top of the noticed interval.
Conclusion
The long-short ETF sector momentum technique by itself doesn’t carry out nicely, making its utility unprofitable. Luckily, there are approaches that may improve this technique. Though the separation into lengthy and brief momentum isn’t very useful independently, the right unbiased settings of lengthy and brief legs can yield environment friendly outcomes. We discovered that combining 4, 5, or 6 sectors with the perfect month-to-month momentum values for lengthy positions, together with 1 sector with the worst month-to-month momentum worth for brief positions (utilized with a weight not exceeding 30%), considerably will increase the technique’s efficiency. This method might be additional improved by going brief solely when the worth of the EW benchmark is under the 12-month shifting common. With this refined technique, the Sharpe ratio reaches glorious values starting from 0.60 to 0.72, and it additionally outperforms the S&P 500 index over greater than 20 years, reflecting its effectiveness.
Creator: Sona Beluska, Junior Quant Analyst, Quantpedia
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