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Sector Rotation Based on Relative Rotation Graphs

Steve LeCompte | | Posted in: Momentum Investing, Volatility Effects

Guide Trend Following and Momentum Asset class and ETF momentum

Key Insight

RRG-based sector rotation (weekly equal-weighted top 5 of 31 sector ETFs entering the RRG improving quadrant; Wilder Volatility Stop; 2% annual fee) produced 16.8% CAGR, 1.39 Sharpe ratio and -9% maximum drawdown (Jan 2013–mid-2023; backtest).

Do Relative Rotation Graphs (RRG), which visually segregate assets into leading, weakening, lagging or improving quadrants by relative performance, effectively identify equity sectors with relatively strong future returns? In his September 2023 paper entitled "Dynamic Sector Rotation", John Rothe tests an RRG-based sector relative momentum strategy with stop-loss risk management based on volatility. Specifically, he:

  • Selects a universe of 31 sector sector/subsector exchange-traded funds (ETFs) based on daily trading volume, years in existence, overlap with other sector/subsectors, assets under management and liquidity.
  • Each week, holds the equal-weighted top 5 ETFs crossing into the RRG improving quadrant.
  • Manages the risk of each holding continuously via a Wilder Volatility Stop with a 5-day range.
  • Assumes a 2% annual management fee.

His benchmark is the S&P 500 Momentum Index. Using weekly returns for the selected ETF universe during a test period spanning January 2013 through mid-2023, he finds that:

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