Tips on how to Enhance ETF Sector Momentum – QuantPedia

Tips on how to Enhance ETF Sector Momentum

On this article, we discover the historic efficiency of sector momentum methods and study how their alpha has diminished over time. By analyzing the underlying causes behind this decline, we determine key components contributing to the underperformance. Most significantly, we introduce an enhanced strategy 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 device for systematic traders.

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, underneath the belief that this momentum will persist. On this article, we discover sector momentum particularly throughout the context of ETFs. We’ve got beforehand examined related methods in Sector Momentum – Rotational System and Business Momentum – Using 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 autos diminished the efficiency of the normal long-short sector momentum. We addressed an analogous problem in Robustness Testing of Nation and Asset ETF Momentum Methods. Our aim on this research is to enhance sector momentum methods, whether or not via long-short or long-only approaches, aiming to reinforce general efficiency regardless of these difficulties. We addressed an analogous concern of bettering momentum methods for commodities in Tips on how to 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 (vitality), XLF (financials), XLI (industrials), XLK (expertise), XLP (client staples), XLU (utilities), XLV (well being care), XLY (client discretionary). All of those ETFs are adjusted for dividends and splits, that means that historic costs have been modified to mirror dividend payouts and inventory splits. This adjustment offers 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 as a result of splits. Utilizing these adjusted costs is essential for exact historic efficiency evaluation and technique comparability. The information had been sourced from Yahoo Finance and signify the day by day adjusted closing costs of the given ETF, protecting the interval from December 22, 1998 to September 5, 2024.

Moreover, it’s vital 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 customary deviation, max dd means maximal drawdown, Sharpe ratio is calculated as a return to a volatility and Calmar ratio as a damaging return to a maximal drawdown.

On this analysis, we calculate the momentum of the ETFs based mostly on the adjusted month-to-month costs of every particular person ETF. For every month, we kind all 9 ETF momentum values from highest to lowest. We then choose an optionally available variety of ETFs to go brief (these with lowest momentum worth) and an optionally available quantity to go lengthy (these with the best momentum worth). 

Step 1 – Benchmark

In step one we concentrate on two benchmarks for our analysis for comparability of effectiveness of the next examined methods. For this function, 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, based mostly on their momentum. For this evaluation, we’ll take into account a 12-month momentum rating interval and 1-month holding interval. 

The three lengthy/3 brief momentum technique has proven poor efficiency, characterised by damaging returns and excessive drawdowns, leading to unfavorable ratios values. The curve of the graph displays an unstable evolution with a declinig tendency, reflecting inefficiency. The one constructive facet of this technique is the seen constructive efficiency throughout market disaster, which point out some hedging properties.

Moreover, we progressively adjusted the rating interval, starting from 1 month to 12 months, and diversified the variety of property on lengthy/brief sides (4v4, 3v3, 2v2, 1v1). Sadly, these modifications didn’t yield any helpful 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 targeted on long-only technique, we determined to set 12-month rating interval for momentum (and 1-month holding/rebalancing interval), as it’s a broadly used interval in most tutorial papers. We utilized this rating interval in each technique case, choosing 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 exhibits promising potential, particularly when choosing 4 or extra sectors to go lengthy. 

Brief-only momentum technique

Much 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, based mostly on the worst month-to-month momentum, after which calculate their efficiency traits.

Primarily based on the efficiency outcomes of every technique, we will conclude that the technique involving the 1 worst momentum sector yields the perfect outcomes, despite the fact that they’re nonetheless damaging. Nevertheless, the stunning truth is that short-only momentum technique that selects 1 ETF doesn’t have as damaging 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 property 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 lowering 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 simpler when it consists of 4, 5, or 6 sectors, whereas the short-only momentum technique achieves probably the most appropriate outcomes by using just one sector. Plus, we’ll 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 will not be set with 100% weight, however solely 5% to 30%. Whereas working with this technique, it’s essential to hold 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 will conclude that the momentum + brief methods are simpler than the S&P 500 or equally weighted benchmark. Subsequently, their software is useful for traders, 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 all the funding interval will not be essential. As a substitute, we aimed to carry the brief place solely when the equally weighted (EW) benchmark (launched in Step 1) was in a damaging pattern – particularly, beneath the 12-month transferring 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 diversified weight settings from 5% to 30% in 5% increments, however solely when the EW benchmark confirmed a damaging pattern. 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 related conduct out there, albeit with totally different development intensities. Our technique has yielded noticeably larger values, demonstrating a bent to develop and outperform the benchmark from 2001 till the tip of the noticed interval.

Conclusion

The long-short ETF sector momentum technique by itself doesn’t carry out effectively, making its software unprofitable. Happily, there are approaches that may improve this technique. Though the separation into lengthy and brief momentum will not be very helpful independently, the right impartial 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 strategy might be additional improved by going brief solely when the worth of the EW benchmark is beneath the 12-month transferring common. With this refined technique, the Sharpe ratio reaches wonderful 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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