Aurora Borealis
1 August 2013 CFA Institute Journal Review

Is There Value in Valuation? (Digest Summary)

  1. Marc L. Ross, CFA

A properly implemented sector rotation strategy has been proved to contribute to improved investment performance. The authors explore what role, if any, valuation plays in generating alpha in sector rotation. Critical to enhanced investment results is consistent identification of the best-performing sectors in advance of any rotation.

What’s Inside?

The authors study the effects of a well-executed sector rotation strategy on portfolio returns. Focusing their inquiry on high-yield bonds, they determine that well-timed exploitation of changes in risk premium rather than valuation accounts for a successful approach.

How Is This Article Useful to Practitioners?

Evidence abounds on the contribution of a properly implemented sector rotation strategy to improved investment performance. The authors focus on high-yield bond rating subdivisions in the Bank of America Merrill Lynch U.S. High Yield Master II Index and consider attempts to generate alpha through a strategy of varying portfolio concentrations in various market sectors based on industry, credit rating, and maturity over time. This approach works if the best-performing rating subdivision can be correctly anticipated.

The authors also test periodic returns of high-yield rating groups as a function of the change in the risk premium of high-yield bonds overall. Lower-rated groups typically outperform (underperform) higher-rated groups when the option-adjusted spread (OAS) on the High Yield Master II Index decreases (increases). They note evidence of incorrect outcomes in quarters with smaller OAS changes. Changes in risk premium, rather than valuation, account for alpha.

Finally, the authors study a robust multiple-regression model that explains OAS variation over time on the basis of five independent variables to determine whether it adds value to a sector rotation strategy among rating groups. Although regression statistics confirm the model’s ability to determine fair value for various rating groups, relative value calculations to gauge the extent of a rating subdivision’s richness or cheapness illustrate that return advantages are rarely statistically significant. That is, valuation fails to play a meaningful role in sector rotation.

Security analysts, traders, and portfolio managers would do well to consider the implications of this analysis.

Abstractor’s Viewpoint

That valuation would fail to play a critical role in sector rotation strategies is counterintuitive. Yet, that is precisely what the authors argue. They conclude that a carefully executed sector rotation strategy that correctly anticipates changes in risk premium among various rating subcategories of high-yield bonds, rather than identification and implementation of opportunities discovered through fundamental analysis, contributes to portfolio alpha. A similar analysis of sector rotation in other asset classes, accounting for any features unique to those classes, is warranted.

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