SystemTrader
ETFsIntermediateMomentum

Sector Momentum Rotation

A tactical strategy that rotates into top-performing sector ETFs based on past momentum. Exploits the well-documented tendency for sector and industry performance to persist over intermediate time horizons.

Universe
11 Sector ETFs
Formation
6-12 Months
Holding
1-3 Months
Rebalance
Monthly

Overview

The sector momentum rotation strategy exploits a powerful market anomaly: the tendency for sector and industry performance to persist over intermediate time horizons. Research shows that momentum exists not only for individual stocks but also for sectors and industries, making ETFs an efficient vehicle to capture this effect.

The strategy is simple: rank all sector ETFs by their past performance (typically 6-12 months), buy the top performers, and hold for 1-3 months. ETFs concentrated in specific sectors offer a simple way to implement sector rotation without having to buy or sell a large number of underlying stocks.

Moskowitz and Grinblatt (1999) demonstrated that industry momentum accounts for much of the individual stock momentum anomaly, with industry momentum strategies being significantly more profitable than individual stock momentum strategies. This persistence creates a systematic opportunity for tactical rotation.

Key Insight

Momentum Persistence
Sectors trend for 6-12 months
ETF Efficiency
Trade sectors with single ticker
Low Turnover
Monthly rebalancing keeps costs low

Sector Momentum Rankings

Sectors ranked by 6-month cumulative returns.Top 3 sectors are selected for the portfolio.

Selected Sectors
Top 3
XLK, XLY, XLC
Average Momentum
+15.2%
Top 3 average
Holding Period
1 Month
Until next rebalance
Selected (Buy)
Positive momentum
Negative momentum

Research

Sector and industry momentum is one of the most robust findings in empirical finance. Research spanning multiple decades and markets confirms that sector performance tends to persist, creating opportunities for tactical rotation strategies.

ETF Era Analysis

The Mathematics

In Plain English

The math behind this strategy is straightforward. Here's what you're actually doing:

  1. 1
    Calculate cumulative return for each sector ETF over the formation period (T months)
  2. 2
    Rank all sector ETFs by their cumulative returns from highest to lowest
  3. 3
    Buy the top-ranked sectors (e.g., top 3 or top decile)
  4. 4
    Hold for the holding period (typically 1-3 months)
  5. 5
    Rebalance monthly by repeating the ranking and selection process
  6. 6
    Optional: Apply moving average filter to avoid buying sectors in downtrends

That's it. The formulas below just express this process precisely.

Technical Formulas

1
Cumulative Return (Momentum Signal)

Formula
R_i^{cum}(t) = \frac{P_i(t)}{P_i(t-T)} - 1

Where P_i(t) is the price of ETF i at time t, and T is the formation period (typically 6-12 months). This measures the total return over the lookback period.

2
Moving Average Filter

Formula
Rule = \begin{cases} \text{Buy top ETFs} & \text{if } P > MA(T') \\ \text{Short bottom ETFs} & \text{if } P < MA(T') \end{cases}

Optional filter: only buy a top-decile ETF if its price P is above its moving average MA(T'), where T' is typically 100-200 days. This avoids buying sectors in downtrends.

3
Dual Momentum Filter

Formula
Rule = \begin{cases} \text{Buy top sectors} & \text{if } P_{market} > MA(T') \\ \text{Buy bonds/cash} & \text{if } P_{market} \leq MA(T') \end{cases}

Augment relative momentum with absolute momentum of a broad market index. Only take long sector positions when the market is in an uptrend; otherwise, move to bonds or cash.

Formation Period SelectionNote

Research suggests 6-12 month formation periods capture the intermediate-term momentum effect. Shorter periods (1-3 months) may capture reversal effects, while very long periods (>12 months) see momentum decay.

Transaction CostsNote

Sector ETFs typically have tight spreads and low expense ratios, making monthly rebalancing cost-effective. Expected turnover is moderate as sector trends tend to persist.

Strategy Rules

Universe Selection

  1. Use the 11 S&P 500 sector ETFs (XLK, XLV, XLF, XLY, XLP, XLE, XLI, XLB, XLRE, XLU, XLC)
  2. Alternatively use Vanguard or iShares sector ETFs for lower expense ratios
  3. Ensure sufficient liquidity (average daily volume > $10M)
  4. Exclude leveraged or inverse ETFs
  5. Consider equal-weighting sectors or market-cap weighting

Ranking & Selection

  1. 1Calculate 6-month or 12-month cumulative returns for each ETF
  2. 2Rank ETFs from highest to lowest momentum
  3. 3Select top 3-5 sectors (or top quintile) for long positions
  4. 4Optional: Select bottom 3 sectors for short positions (long/short version)
  5. 5Equal-weight selected sectors or momentum-weight them

Rebalancing Rules

  1. Rebalance on a fixed schedule (monthly on first trading day)
  2. Recalculate rankings using most recent data
  3. Replace sectors that fall out of top ranks
  4. Keep sectors that remain in top ranks (reduce turnover)
  5. Consider a 1-month skip period to avoid short-term reversal

Risk Management

  1. 1Apply moving average filter to avoid buying downtrending sectors
  2. 2Use dual momentum: move to bonds when market trend is negative
  3. 3Position size each sector equally or by volatility
  4. 4Set maximum allocation per sector (e.g., 25%)
  5. 5Monitor for momentum crashes during sharp market reversals

Implementation Guide

Implementing sector momentum rotation is straightforward with modern ETFs. The key is consistent execution of the ranking and rebalancing process.

1

Define Your Universe

Start with the 11 S&P 500 sector ETFs (SPDR Select Sector series). These provide broad coverage of the US equity market with good liquidity and tight spreads.

Tips
  • XLK (Technology), XLV (Healthcare), XLF (Financials), XLY (Consumer Discretionary)
  • XLP (Consumer Staples), XLE (Energy), XLI (Industrials), XLB (Materials)
  • XLRE (Real Estate), XLU (Utilities), XLC (Communication Services)
  • Alternative: Vanguard VGT, VHT, VFH, etc. for lower expense ratios
2

Calculate Momentum Signals

For each ETF, calculate the cumulative return over your chosen formation period. Most implementations use 6-month or 12-month returns, excluding the most recent month to avoid short-term reversal effects.

Tips
  • Use adjusted close prices (dividend and split adjusted)
  • Calculate: (Price_today / Price_6mo_ago) - 1
  • Consider skipping the most recent month (12-1 momentum)
  • Data sources: Yahoo Finance, Alpha Vantage, or your broker
3

Rank and Select Sectors

Rank all 11 sectors by momentum from highest to lowest. Select the top 3-5 sectors for your portfolio. Research suggests holding 3-5 sectors balances concentration with diversification.

Tips
  • Top 3 sectors: more concentrated, higher tracking error
  • Top 5 sectors: more diversified, closer to market returns
  • Equal-weight selected sectors for simplicity
  • Record your rankings for performance tracking

Avoid over-concentrating in a single sector. Even top momentum sectors can reverse sharply.

4

Apply Optional Filters

Enhance the basic strategy with a moving average filter or dual momentum approach. Only buy sectors that are above their 200-day moving average, or only invest when the broad market is trending up.

Tips
  • Simple MA filter: Sector price > 200-day MA
  • Dual momentum: SPY price > 200-day MA, else hold AGG (bonds)
  • These filters reduce drawdowns but may reduce returns in choppy markets
5

Execute and Rebalance

Execute trades on your rebalancing date (e.g., first trading day of each month). Sell sectors that dropped out of the top ranks and buy new sectors that entered. Hold positions that remain in the top ranks.

Tips
  • Use limit orders slightly above bid for sells, below ask for buys
  • Rebalance at the same time each month for consistency
  • Track turnover - expect 2-4 sector changes per month on average
  • Consider tax implications in taxable accounts

Broker Requirements

This strategy can be implemented at any broker that offers sector ETFs. No special account type is required for long-only versions. Commission-free ETF trading is widely available, making monthly rebalancing cost-effective.

Helpful Tools & Resources

Data & Screening
Finviz, TradingView, Portfolio Visualizer
Backtesting
Portfolio Visualizer, Quantconnect
Execution
Schwab, Fidelity, Interactive Brokers

Strategy Variations

Explore different ways to implement this strategy, each with its own trade-offs and benefits.

Dual Momentum Sector Rotation

Combine relative momentum (sector ranking) with absolute momentum (market trend filter). Only invest in sectors when the broad market is above its moving average; otherwise, hold bonds.

Reduces drawdowns significantly during bear markets.

Moving Average Filter

Only buy top-momentum sectors if their price is above the 200-day moving average. Avoids buying sectors in technical downtrends even if they rank highly on recent momentum.

Adds a trend-following overlay to momentum.

Long/Short Sector Rotation

Go long top 3 sectors and short bottom 3 sectors. Creates a dollar-neutral portfolio that profits from sector dispersion regardless of market direction.

Requires margin account and short-selling capability.

Global Sector Rotation

Expand the universe to include international sector ETFs or country ETFs. Captures momentum across global markets and increases diversification.

Consider currency effects and trading hours.

Risk Parity Weighting

Instead of equal-weighting selected sectors, weight them inversely by volatility. Lower-volatility sectors get higher allocations, potentially improving risk-adjusted returns.

Requires volatility estimation and more frequent rebalancing.

Consider combining multiple variations or testing them against your specific investment goals and risk tolerance.

Risks & Limitations

High(2)
Medium(3)
Low(1)
Momentum CrashesHigh

Momentum strategies can experience severe losses during sharp market reversals. When market sentiment shifts quickly, past winners become losers rapidly. The 2009 momentum crash saw significant drawdowns.

Impact:
Sector ConcentrationHigh

Holding only 3-5 sectors means significant concentration risk. A single sector can represent 20-33% of the portfolio, amplifying the impact of sector-specific negative events.

Impact:
Declining AlphaMedium

Research suggests sector momentum alpha has diminished over time as the strategy became widely known and ETFs increased market efficiency. Past performance may not predict future returns.

Impact:
Whipsaw in Choppy MarketsMedium

In range-bound or choppy markets without clear trends, the strategy may experience frequent sector rotations that generate losses. Moving average filters help but don't eliminate this risk.

Impact:
Crowded Trade RiskMedium

Sector momentum is a well-known strategy. When many investors follow similar signals, entry and exit points become crowded, potentially reducing returns and increasing volatility at rebalancing dates.

Impact:
Transaction Costs and SlippageLow

Monthly rebalancing generates turnover and trading costs. While sector ETF spreads are tight, frequent trading in taxable accounts can create tax drag from short-term capital gains.

Impact:
Understanding these risks is essential for proper position sizing and portfolio construction. Consider combining with other strategies to mitigate individual risk factors.

References

  • Moskowitz, T.J. & Grinblatt, M. (1999). Do Industries Explain Momentum?. The Journal of Finance, 54(4), 1249-1290 [Link]
  • Antonacci, G. (2012). Risk Premia Harvesting Through Dual Momentum. SSRN Working Paper (NAAIM Founders Award Winner) [Link]
  • O'Neal, E.S. (2000). Industry Momentum and Sector Mutual Funds. Financial Analysts Journal, 56(4), 37-49 [Link]
  • Beluská, S. & Vojtko, R. (2024). How to Improve ETF Sector Momentum. SSRN Working Paper [Link]

ETF trading involves risk of loss. Sector rotation strategies may underperform buy-and-hold during certain market environments. Past performance of momentum strategies does not guarantee future results. This is educational content, not investment advice.

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