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Wednesday, December 24, 2014

Portfolio Management





An Investment Strategy based on  Recent Sector Performance



11/24/2014










Introduction

 This report will evaluate a sector rotation investment strategy by back testing using a risk adjusted performance evaluation and other fundamental analysis.  To test the strategy, exchange traded funds (ETFs) offered by Vanguard will be used.  Vanguards ETFs were deemed preferable because the company does not charge trading fees for its own ETFs if you use a Vanguard brokerage account.  The elimination of such trading fees can make a very significant difference in portfolio performance over time given that most brokerage firms charge at least $4.50 per trade.  Vanguard brokerage services charges $7.00 per trade, for non-Vanguard ETFs, stocks, or mutual funds.  However, Vanguard’s offerings include the main market index, sector, and international ETF types and offer the lowest expense ratios in the industry.  Therefore, it is possible to build a portfolio mainly consisting of Vanguard offerings suitable for the majority of individual investors.  Leaving the free Vanguard advertisement behind, the following paragraphs will discuss the actual strategy to be evaluated.  The strategy is not very difficult or time consuming to implement.  Most importantly, the question this report hopes to answer is if implementing such a strategy adds alpha to a portfolio.
            Vanguard offers ETFs that cover most of the main industry sectors that make up the U.S. economy.  This portfolio strategy involves purchasing those sectors that underperformed by the most and selling those industries that outperformed the most in the prior quarter.  The idea is that an investor would be purchasing the underperformers at relatively low valuations while selling those industries that may be overvalued because of their recent run up.  This approach goes along with several well known investment ideas, such as the concept that prices tend to revert to the mean over time.  There is a related strategy for stocks in which investors purchase the worst performing stocks in the Dow Jones Industrial average of the prior year.  The expectation based on some historical data is that these stocks will outperform the overall Dow Index in the following year.  As is often the case in the markets, investors tend to be overly exuberant on in good times, and then overly pessimistic when the market is declining. 
Another concept that that was also considered is purchasing those industries that have the lowest price to earnings multiple (PE ratio) and sell those with the highest PE ratios.   This strategy is more difficult to implement in practice and more difficult to back test.  For one, different industries historically trade at vastly different PE ratios.  For example, technology stocks always trade at higher valuations than utilities because of the higher growth forecasts associated with the technology industry.  Technology stocks are often fast growing innovative companies with room for expansion while utilities largely operate in a mature and regulated marketplace.  Therefore, using PE ratios alone would lead an investor to only purchase certain industries missing out on opportunities such as mispriced technology stocks.


Data

The table below provides the various Vanguard sector ETFs offered that will be used in this analyses.
Name
Symbol
Expense
 ratio
As of 11/24/2014
Average annual total returns as of 09/30/2014*
YTD returns
1 year
3 year
5 year
10 year
Since inception
1
Consumer Discretionary ETF
VCR
0.14%
1.24%
7.12%
10.77%
26.43%
21.29%
9.59%
8.62%
(01/26/2004)
2
Consumer Staples ETF
VDC
0.14%
2.38%
14.47%
15.91%
18.42%
15.67%
11.02%
10.30%
(01/26/2004)
3
Energy ETF
VDE
0.14%
2.19%
-0.17%
11.76%
16.99%
12.19%
11.47%
11.71%
(09/23/2004)
4
Financials ETF
VFH
0.19%
2.09%
11.92%
15.94%
25.68%
11.29%
1.50%
1.38%
(01/26/2004)
5
Health Care ETF
VHT
0.14%
1.19%
24.81%
26.96%
29.21%
20.03%
10.99%
9.60%
(01/26/2004)
6
Industrials ETF
VIS
0.14%
1.68%
9.11%
14.70%
25.43%
17.16%
8.96%
9.12%
(09/23/2004)
7
Information Technology ETF
VGT
0.14%
1.25%
18.16%
25.39%
22.05%
15.83%
9.91%
7.25%
(01/26/2004)
8
Materials ETF
VAW
0.14%
1.84%
8.91%
17.86%
21.90%
13.71%
9.34%
9.75%
(01/26/2004)
9
Telecommunication Services ETF
VOX
0.14%
3.17%
6.41%
12.14%
16.88%
13.35%
8.68%
8.65%
(09/23/2004)
10
Utilities ETF
VPU
0.14%
3.22%
21.11%
15.73%
12.63%
12.30%
9.38%
9.55%
(01/26/2004)


Due to the inception dates provided in Table 1, the analyses that follows will be based on data spanning from October 2004 through October 2014 as all of the funds have data for this period.  Additionally the performance of this investment strategy will be compared to the performance that could have been achieved by simply investing in Vanguard’s Total Stock Market ETF (VTI).  This ETF tracks the performance of the entire U.S. stock market using market capitalization weightings.      
Name
Symbol
Expense
ratio