DAVID GIBBS, DIRECTOR, INTERNATIONAL MARKET DEVELOPMENT JANUARY 2017

CME GROUP

Enhancing Investment Performance of a U.S. Equity

Portfolio Utilizing a Sector Rotation Strategy
CASE STUDY: SECTOR ROTATION POST U.S. ELECTION

Background Different sectors of the economy respond differently to

changes in the flow of the business cycle. Some sectors may
“The business cycle, which reflects the fluctuations of activity
either outperform or underperform others during certain
in an economy, can be a critical determinant of equity sector
phases of a cycle. One commonly accepted practice among
performance over the intermediate term. A typical business
Materials, 2.9%
Real Estate, 2.9%
active managers of equity portfolios is to increase allocations
cycle features a period of economic growth, followed by a
Utilities, 3.1%
into sectors expected to outperform as they begin their ascent
period of slowing growth and then a contraction, or recession.
and rotate out of or decrease allocations from sectors they
The cycle then repeats itself.”1
Energy
expect to underperform or lag versus the broader market.
There are typically 7.3%four phases to a business cycle: 1) Early-

cycle or recovery, 2) mid-cycle, or expansion,

Technology 3) late-cycle, or Sector Early Mid Late Recession
23.6%
contraction, then
Consumer 4) recession. Each phase is characterized by
Staples Financials +
9.2%
differences in economic growth, credit conditions, monetary Real Estate* ++ --
and fiscal policy
10.2%
influences, and inventory
Industrials
Financials
cycle. Consumer ++ --
14.7% Discretionary
According the National Bureau of Economic Research (NBER), Info Technology ++ + -- --
between the years 1945-2009
Consumer Disc.
the U.S. went through 11 cycles.
Health Care
12.2% 13.9%
Industrials ++ + --
The cycles have averaged a little less than six years in length
Materials -- ++ -
with an average expansion period of 58.4 months and an
Consumer Staples - + ++
average contraction period of 11.1 months.2
Health Care - ++ ++
Energy -- ++
Telecom -- ++
1. Utilities -- - + ++
RECOVERY * As of Aug. 31, 2016, real estate was elevated from an industry in the U.S. financials
(early) sector to the 11th sector per the Global Industry Classification Standard. Unshaded
(white) portions above suggest no clear pattern of over- or underperformance vs.
broader U.S. equity market. Double +/- signs indicate that the sector is showing a
consistent signal across all three metrics: full-phase average performance, median
monthly difference, and cycle hit rate. A single +/- indicates a mixed or less consistent
signal. Source: Fidelity Investments (AART).

4. 2.
EXPANSION It is commonly accepted to look at sectors as defined by the
RECESSION
(mid)
Global Industry Classification Standard (GICS®) which currently
assigns each index component to one of eleven Sectors, or “Level
1” GICS: financial, real estate (formerly in the financial sector),
consumer discretionary, info technology, industrials, materials,
3. consumer staples, health care, energy, telecom, and utilities. The
CONTRACTION
(late) widely referenced U.S. equity market benchmark S&P 500 Index
is made up of 500 of the largest U.S. companies and represents
approximately 80% of the total U.S. market capitalization. The

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 JANUARY 2017

S&P 500 Index comports with the GICS index taxonomy and Case Study: Sector Rotation Using Select Sector Futures
therefore each of the 500 companies in the index is assigned into
For this study we assume a $5 billion total equity position
one of the eleven Level 1 GICS.
benchmarked to the S&P 500 Index. We will consider the
While portfolio managers employ sector rotation strategies effects of a 3% adjustment out of the Utilities sector (Select
based on their views of the current and enfolding business Sector symbol XAU) into the Financial sector (Select Sector
cycle they may also utilize sector rotation strategies to symbol XAF) from November 9 to December 15, 2016. Why
take advantage of opportunities created by an unforeseen this rotation?
financial or geo-political event. The recent U.S. election,
With the surprise election of Donald Trump to the U.S.
held November 8, 2016 was one such event and provided an
Presidency there could be a good case to be more heavily
environment to possibly create alpha from anticipated shifts
allocated to financials versus utilities. Financial shares should
in sector valuations. This case study will consider the effects
benefit from campaign promised reduction in regulation.
of a short-term sector rotation trade using CME Group’s
Additionally, increased promised infrastructure spending and
E-mini S&P Select Sector futures contracts on a large S&P
anticipated additional employment could drive wage inflation
500 Index benchmarked portfolio.
leading to more frequent Fed rate hikes. Rising interest rates
CME Group offers a wide range of equity index exchange tend to favor the financial sector. On the flip side, higher
traded derivatives (ETDs) including futures and options on interest rates tend to have a negative effect on utility shares.
futures on benchmark indices like the S&P 500, Dow Jones
Industrial Average, NASDAQ-100, and futures on non-USD How to structure the trade? Select Sector futures are equity
indices like the Nikkei-225, FTSE China 50, the Nifty 50 index products so, like other equity index products, they have
Index and others. They also list 10-Select Sector futures an index value and a contract multiplier. To calculate the
contracts covering the Level 1 GICS of the S&P 500 index. number of futures contracts necessary to affect the sector
Notice 10-futures versus the 11-Level 1 GICS of the S&P 500 rotation we take the percentage value of the adjustment in
Index referred to earlier. The ten futures contracts follow the financial (USD) terms and divide it by the financial, or notional
S&P Select Sector indexing methodology established and value, of the Select Sector futures contract. Since we wish
maintained by SPDJI, the index provider, where the two Level to rotate 3% of the portfolio total value from utilities into
1 GICS Information Technology and Telecommunications are financials the adjustment value would be:
combined to form the Technology Select Sector Index. The
chart below shows the Select Sector futures contracts and Adjustment value (AV) = 3% of total value =
their percentage allocation of the S&P 500 Index. $5 billion x 3% = $150 million

Real Estate, 2.9% Materials, 2.9% Review the table below.

Utilities, 3.1%

Adjustment
Index Notional amount
value Contract value (AV ÷ NV in
Energy Sector Symbol Nov. 9 Multiplier (NV) contracts)
7.3%
Financial XAF 255.90 $250 $63,975 2,345
Technology
23.6% Utilities XAU 475.80 $100 $47,580 3,153
Consumer Staples
9.2%
Source: Bloomberg and CME Group

Industrials
10.2% Financials
14.7%

Consumer Disc. Health Care

12.2% 13.9%

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By performing the simple mathematics of multiplying each Change Since November 8, 2016
Change Since November 8, 2016
Select Sector index value times its respective contract
multiplier we derive the contract’s notional value. Then we 20.0%

divide the contract’s notional value into the adjustment value 16.2%
15.0%
to arrive at the number of futures contracts to use in the
sector rotation. We want to increase the exposure to financials 10.0%
8.1%
and decrease the exposure to utilities. Therefore, we would 5.9%
7.3% 7.5%

4.3% 4.5%
buy 2,345 Financial (XAF) Select Sector futures and sell 3,153 5.0%

Utilities (XAU) Select Sector futures.

0.0%

One of the advantages of using standardized listed futures -2.2% -2.0%

-5.0%
is the capital efficiency they provide. Compared to a basket

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of the underlying stocks or a sector ETF which require full

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payment upon purchase, futures require performance bond,

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Source: Bloomberg Professional (IXS1, IXR, IXT, IXY, IXD, IXC, IXP, IXI, IXA)
or margin, which is usually a fraction of the notional amount
of the contract. For example, the margin required on XAF and
XAU is roughly 4.7% and 3.5% respectively, of their notional
value. Margins are set by CME Clearing and reflect the risk Using settlement prices from November 9 to establish our
of the perceived maximum daily price change per contract. study’s opening positions, let’s track them to a closing position
Margins are subject to change based on market conditions on December 15, 2016 and evaluate the results.
and volatility.
Sector Nov 9 Dec 15 Change % change
Case Study: Market Simulation S&P 500 (ES) 2160.25 2263.50 +103.25 +4.8%
When it became clear that Mr. Trump would be the winner of Financial (XAF) 255.90 290.80 +34.90 +13.6%
the election it was the middle of the night in the United States.
Utilities (XAU) 475.80 484.60 +8.80 +1.9%
Cash equity and ETF markets in the U.S. were closed. But
CME Group’s electronic trading platform, CME Globex, was Source: Bloomberg and CME Group
open. Equity index products, including E-mini S&P 500 and
Select Sector futures were open and trading as they are every During the time frame considered the S&P 500, as measured
trading day beginning at 5:00PM Chicago time and closing by the E-mini S&P 500 futures, increased by 4.8%. The
the following day at 4:00PM. The initial reaction by E-mini S&P Financials Select Sectors (XAF) increased by 13.6% surpassing
500 futures (symbol ES) was a sell-off. However, somewhere the benchmark by 8.8%. The Utilities Select Sectors (XAU)
around the middle of the night session (U.S. time) bullish increased by 1.9% which was less than the increase of the
sentiment gained strength and eventually over powered the broad index and significantly less compared to XAF.
bears pushing index futures higher. By the opening of U.S.
Contract Points Multiplier Amount P&L
stock markets on Wednesday 9 November index values were
higher and continued to trade higher still through November XAF +34.90 $250 2,345 $20,460,125
and into late December. Encouraged by the prospects of lower
XAU -8.80 $100 3,153 ($2,774,640)
corporate taxes and possible repatriation of capital, efforts
supported by the President-Elect, the broad market moved Net $17,685,485
higher. But as illustrated by the chart below this “rising tide”
did not lift all of the sector “boats” equally.

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Considering these results, a 4.8% return on a $5 billion position This total margin of $10,056,600 compares favorably to the
would have created a gain of $240 million. An additional $17.7 total of the individual margins combined of $12,237,450. An
million from the Select Sector rotation trade would have added even more favorable comparison would be to consider the
30.0 bps (0.30%) of alpha boosting the total return to 5.1%. cost of capital needed to construct a similar rotation trade
How much capital would have been required? As previously using ETFs, assuming you could borrow the Utilities ETF to
mentioned futures require performance bond, also known as create the short position.
margin, to open and maintain a position. Some central clearing
Summary
counterparties (CCPs) or clearing houses (CH) offer margin
reductions, or off-sets, when highly correlated products are Sector rotation as a risk management or tactical trading
positioned against each other. CME Clearing offers margin strategy is common among large actively managed equity
offsets in the form of discounted margin for correlated products funds. CME Group Select Sector futures are an effective tool
like Select Sector futures. for sector rotation strategies because of their high correlation
to the sector indexes. As exchange traded derivatives they
In our case the net initial margin would be calculated using a
enjoy lower capital usage charges than ETFs and swaps. As
formula that takes the maximum amount of equally offsetting
liquid electronically executed instruments their market impact
contracts and reducing their combined margin by the CH
and transactions cost also tend to be lower than alternative
established discount factor. The balance of remaining open
products. Additionally, they are available vertically around the
contracts would be margined at full margin value. For example,
clock to manage event risk.
our trade position was long 2,345 XAF and short 3,153 XAU. So,
2,345 contracts would be considered offsetting and reduced by David Gibbs
a discounting factor of 20%. The remaining 808 XAU contracts Director, International Market Development
would be margined as individual open contracts. Therefore, if +1 312 207 2591
the margin on XAF is $3,000 per contract and the margin on [email protected]
XAU is $1,650 per contract we get the following result:
For additional commentary see, “Equities: Driven by Trump or
Contract Amount Margin* Total Macroeconomics?” January 17, 2017, Erik Norland, CME Group.

XAF 2,345 $3,000 $7,035,000 Endnotes

XAU 2,345 $1,650 $3,869,250
1. “An Introduction to sector rotation strategies,” Fidelity
Sub total $10,904,250 Learning Center, http://www.fidelity.com/learning-
20% (2,180,850) center/trading-investing/markets-sectors/intro-sectors/
intro-sector-rotation-stats
$8,723,400

XAU 808 $1,650 $1,333,200 2. National Bureau of Economic Research,

http://nber.org/cycles.html
Total $10,056,600
Source: CME Group, * margins subject to change without notice

Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose
more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds
should be devoted to any one trade because they cannot expect to profit on every trade. All references to options refer to options on futures.

Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)12 of the Commodity Exchange Act. Swaps
are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a swaps position. Therefore, traders
should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade.

Any research views expressed are those of the individual author and do not necessarily represent the views of the CME Group or its affiliates.

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presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.

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