December 10, 2010 Leave a comment
A couple days ago, I looked at how buying the best performing sectors can outperform the market. In this post, I try to reduce false signals.
From the results of many research papers on momentum, is should be safe to assume that high momentum stocks outperform low momentum stocks. If we transfer this assumption to the sector rotation strategy, we would also assume that high momentum sectors outperform low momentum sectors. This has, for the most part, been the case with the Top 1, Top 2, and Top 3 portfolios outperforming the market. However, when we look at the performance of those three portfolios relative to each other, it no longer seems to hold true. The holdings of the Top 1 portfolio have, on average, higher momentum than the Top 2 and Top 3 portfolios and therefore we would expect higher returns. In the Fidelity sector version, this has been the case, but with the ETF version there was not much of a difference in performance. If I apply the same momentum strategy to the iShares Dow Jones sector ETFs, than the results are even worse, with Top 1 significantly underperforming Top 2 and Top 3.
So how can we explain the results?
I think this has to do with trades that are quickly reversed such as buying a sector one month and selling it the next or selling a top performing sector that is temporarily ranked second or third. In a portfolio with multiple holdings, this occurs much less frequently than with one holding because there is more room for a small change in rankings. When it does happen, then the effect on performance is smaller because that holding is only a part of the portfolio.
So the simple way to reduce false signals is to increase the number of holdings, but it also increases the number of trades. The Top 1 portfolio has 49 trades, while the Top 2 has 81.
The best solution I have found so far is to add a range of rankings where the sector is a “hold”. Sectors are bought if they are above the hold range, and sold only if they drop below it. With the Top 1 portfolio, we can specify the second place ranking as the “hold” range. The top 1 sector is bought if another sector has been sold, and held until it drops to third place or below. This improves the performance and almost cuts in half the number of trades to 27.
I think that this method is a good idea when several of the potential holdings have high correlation. Sectors of the stock market tend to have a high correlation and so this improves returns by avoiding some trades that are quickly reversed.