Pick the Winning Sectors

This article is published with permission from InvestmentU.com.

With dividends reinvested, the S&P 500 returned an average 9.01% annually over the last 20 years.

That means you would have made 461% over that period, turning a $10,000 investment in 1994 into $56,147 today.

But you could have turned that $10,000 into $145,105 by adding an additional 5.3% to that return. That's roughly what relative strength rebalancing can deliver in market outperformance.

I've read countless studies about relative strength rebalancing, and I'll summarize 2 of those studies today to demonstrate how I arrived at that 5.3% figure. Then, I'll show you how to easily use the strategy yourself.

One study compared the performance of 1,000 large cap stocks to that of the top 25% best-performing stocks in the group (excluding the most recent month) from 1927 through 2009. The average performance of the group overall is represented by the 0% line in the chart.

The strategy outperforms the group most of the time with an average annual outperformance of 4.3%.

A separate study demonstrates even better returns using relative strength rebalancing. As you can see in the next chart, the researchers found a 6.28% average annual outperformance above the benchmark (in this case the S&P 500) for relative strength rebalancing, or "RS Alpha" in the researchers' parlance.

I averaged these 2 studies to approximate the 5.3% outperformance that I cite.

(Although the studies are concerned with time periods of 80 years or more, the relative strength outperformance over the last 20 years would have been even better, given the inclusion of three strong market periods during that time.)

You have options

There are many ways to approach this strategy. The approach we've discussed recently in Investment U involves sector rotation—investing in a handful of the top-performing sector ETFs each quarter. That's easier than having to track hundreds of individual stocks every quarter.

I use this web page to identify the top 10% of sector ETFs over the prior quarter. It usually turns up 13 or 14 ETFs.

ETFs give you all the diversification you'll need. Owning 3 to 5 of them is fine because that would likely indirectly position you in 50 to 100 stocks.

Be sure to eliminate from your selection funds that own commodities rather than stocks—like the United States Natural Gas Fund (NYSE: UNG), which owns natural gas. You should also eliminate duplicate-sector funds. Don't overweight yourself in any one sector.

Let's see how this strategy has been working...

When I introduced this strategy in December, I cited ETFs that track brokers, iShares US Broker-Dealers (NYSE: IAI); banking, SPDR S&P Regional Banking ETF (NYSE: KRE); pharmaceuticals, SPDR S&P Pharmaceuticals ETF (NYSE: XPH); and aerospace, PowerShares Aerospace & Defense (NYSE: PPA).

The first-quarter returns of those ETFs averaged 3.34% compared to the S&P 500's 1.7%, for a 1.64% outperformance. That's an annualized outperformance of 6.56%.

Let's look at prior quarters. I first started publishing this strategy on July 2, 2013, in "These ETFs Will Lead the Next Rally." Below are the 5 sector ETFs I identified at that time, and their quarterly return compared with the S&P 500.

Now check out the following 3-month return of those ETFs.

And here's the combined 6-month return of the 5 ETFs.

There are many different methods of relative strength rebalancing. You might look back at the previous quarter, 6 months, or year. You might choose to exclude the most recent month's performance (which is like waiting until May 1 to implement the strategy based on the first quarter's top performers). And, of course, you can use the strategy with individual stocks as well as industry sectors.

When we discussed this strategy in December, we picked sector ETFs using a 3-month look-back. Now, we'll start tracking sector ETFs using a 12-month look-back. Here's a screenshot of the top 15 best performers over the past 12 months.

Generally speaking, the strategy outperforms the most during less volatile up markets and when coming off of market lows. So with all the tax-selling to pay for last year's gains, the market is offering you opportunities to buy the strong sectors at a bit of a discount.

I can't wait to review the results in early July.

Chris Rowe is the Oxford Club’s director of Investor Education. Read more by Chris here.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.