US Sector Rotation with Five-Factor Fama-French Alphas

Abstract

In this paper we investigate the risk-adjusted performance of US sector portfolios and sector rotation strategy using the alphas from the Fama-French five factor model. We find that fivefactor model fits better the returns of US sector portfolios than the three factor model, but that significant alphas are still present in all the sectors at some point in time. In the full sample period, 50% of sectors generate significant five-factor alpha. We test if such alpha signifies a true sector out/underperformance by applying simple long-only and long-short sector rotation strategies. Our long-only sector rotation strategy that buys a sector with a positive five-factor alpha generates four times higher Sharpe ratio than the S&P500 buy-and-hold. If the strategy is adjusted to switch to the risk-free asset in recessions, the Sharpe ratio achieved is tenfold that of the buy-and-hold. The long-short strategy fares less well.

An Empirical Analysis on Performance of the Fama and French Five-Factor Model in Different Industries

“…However, they do not test the model's performance in different industries. Additionally, Sarwar, Mateus, and Todorovic looked into the risk-adjusted performance of US sector portfolios using FF5 [7]. They discovered that the five-factor model, as opposed to the FF3 model, better predicted the returns of US sector portfolios, but all sectors still saw significant alphas from time to time.…”