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A long time ago – when I was just a budding “systems developer” – I stumbled across a simple trading method for trading sector funds. For a while I kept it under my hat, because the one thing I kept hearing over and over was that sector funds were “risky." The overarching theme of most commentary regarding sector funds is that they were “volatile” and “unpredictable." And to some extent I found these comments to be true. However, I also found out two other things on my own.

First, volatility can be a good thing if you are on the right side of the market because it can cause you to make more money faster.

Secondly, while sectors and industry groups may in fact be “unpredictable” in the short run, the fact of the matter is that sectors and groups are among the best “trending” trading vehicles. This makes a great deal of intuitive sense if you stop and think about it for a moment. When the fundamentals change for the better for an entire industry group it typically takes a long time for the trend in fundamentals to change back to the negative side. So a given group or sector can advance for as long as several years.   

Pure Momentum

I spent countless hours trying to improve my original system and in fact did stumble across some interesting variations. But the simple core approach has basically been my “bread and butter” for a lot of years. I first wrote about it Technical Analysis of Stocks and Commodities magazine in 1999. I refer to this method as Pure Momentum (PM for short). This week, let’s revisit this simple, yet highly effective trading method.

The “Rules”

The trading “rules” – such as they are – are quite simple:

• At the end of each month, identify the five Fidelity Select Sector funds that have performed the best over the past 240 trading days.
• Then buy and hold those funds until the end of the next month and repeat the process.
• For the record, this system ignores Fidelity Select Gold (FSAGX). Although that fund has been a strong performer in the last year or two, it has a long history of fluctuating in fits and starts.   

That’s all there is to it. Most months there is at least one trade. Some months there are two, and on rare occasions, three funds may be sold and three new funds are purchased. All in all, a pretty simple affair. Which begs the obvious question – can it really be that simple? Well, as a matter of fact, it can. Assuming of course you are prepared to deal with life in the real world.

No one should have any illusions that this is a get-rich-quick scheme. Likewise, no one should expect that there will not be some pain experienced along the way. To wit, the overall portfolio suffered a peak-to-valley decline in excess of –30% during the 2000-2002 bear market. So why should anyone pay attention? Let’s take a closer look.

The Results

Table 1 displays the year-by-year results from investing using Pure Momentum versus buying and holding the S&P 500 Index.

Table 1 – Pure Momentum versus S&P 500

A few notes of interest from Table 1:

• PM witnessed 15 “up” years and 3 “down” years
• SPX witnessed 13 “up” years and 5 “down” years
• PM outperformed SPX 13 out of 18 years
• Between 1990 and the end of 1999, PM gained +1,336%
• Between 1990 and the end of 1999, SPX gained +321%
• Since 1999 PM has gained +149%
• Since 1999 SPX is unchanged
• During the calendar years 2000 through 2002, SPX lost -40%
• During the same time, PM lost only –5%

The Present

It should come as no surprise that the present portfolio is heavily laden with energy funds.

Table 2 – Pure Momentum Portfolio

Summary 

In the short run, sectors and industry groups can be volatile and unpredictable. Ah, but investing is a long-term endeavor. While sector funds can clearly have their ups and downs, in the long run, well chosen sector funds – those investing in the sectors whose fundamentals are improving – have vastly outperformed the overall market.

At this point it would seem to be pretty tough to make the argument that an investment in an S&P 500 index fund is a superior long-term investment to the supposedly “risky” sector funds.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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