Markets and economies move in cycles. And so do sectors within a market – in a way that’s more predictable than you might think.
Sectors of the stock market do better, or worse, each year as their component stocks perform well, or perform poorly. The chart below shows the performance for each sector of the Bloomberg World Asia Pacific Index by year. Each year’s best-performing sector is highlighted in green, while the worst-performing sector is highlighted in red (the overall index’s performance is the first row). So, for example, in 2014, the index rose 11%, while the consumer discretionary sector was the market’s worst performer, with a 3% decline. The financial sector was the best, with a 23% gain.
There’s no clear pattern from one year to the next. But what’s clear is that the best performers don’t stay on top for long – and there’s a lot of movement between the best- and worst-performing sectors.
The table below shows how the different sectors performed for the past 11 years. Consumer staples has been the best performing sector, with the highest annual average return. Utilities and materials have been the worst.
We back-tested three different sector rotation strategies to see how they compare to the performance of the overall Bloomberg World Asia Pacific Index:
Strategy 1: Invest equal amounts in each sectors (that is, 10% of a portfolio in each of the 10 sectors). This is different from owning the overall index, which is weighted by the relative size of each sector (that is, the market capitalization of the component stocks). Each year, the portfolio was rebalanced to account for performance. So if one sector does well and accounts for 13% of the index, it’s cut back down to 10% at the end of the period (and the sector that’s fallen to only 7% is brought back up).
Strategy 2: Buy only the worst-performing sector of the year at the beginning of the following year (buy the worst-performing sector of 2013 as of the first day of trading of 2014), and hold it for a year. Do the same thing at the beginning of the following year, and so on.
Strategy 3: Buy only the best-performing sector of the year at the beginning of the following year (buy the best-performing sector of 2013 as of the first day of trading of 2014), and hold it for a year. Do the same thing at the beginning of the following year, and so on.
Strategies 1 and 2 both far outperformed the index and Strategy 3. The index returned 6% per year. Strategy 2 (buy each year’s worst performer at the start of the next year) returned nearly 13% a year. That’s more than double the index, and more than the single best-performing sector.
But buying last year’s hot sector – Strategy 3 – was the big loser. Jumping on the bandwagon was the worst way to invest. It performed far worse than the index, with an average return of just 4.7%.
What does this mean for 2016? The worst-performing sector last year was energy. If commodity prices remain weak, it could be again (unusually, the worst-performing sector in 2012, energy, was the worst-performing sector again in 2013). But if you don’t think that will be the case again, Asia’s energy sector would be a great way to follow this sector rotation strategy.
The easiest way to invest in sectors is to use an exchange traded fund (ETF) that tracks the sector. Unfortunately, there are very few sector ETFs in the Asia Pacific market. The next best option – for do-it-yourself investors – would be to buy the biggest companies that are components of the sector. For the energy sector, that includes PetroChina Co (ticker 0857 on the Hong Kong Exchange), China Petroleum & Chemical Corp (Sinopec; 0386 on Hong Kong), Reliance Industries Ltd (RIL on India’s National Stock Exchange), CNOOC (0883, Hong Kong), and China Shenhua Energy Co Ltd. (1088, Hong Kong). These five companies account for 54% of the energy sector index.
Markets move in cycles that can sometimes be predictable, most of the time. Last year’s worst performing sector may be this year’s best – or the cycle may be longer this time. If it’s not, though, Asia’s energy sector could do better than the index this year.
