Absorption Ratio for Equity Sector Rotation

Summary

This sector-rotation study uses the absorption ratio to measure how concentrated the risks embedded in a group of asset returns are. The ratio reflects the share of total return variation explained by a small set of orthogonal components: higher readings are interpreted as more concentrated systemic risk and weaker diversification, while lower readings suggest stronger diversification. The study reports a negative relationship between the current ratio and subsequent sector returns, with a mean monthly Rank IC of -0.083, a t-statistic of -2.84, and a 0.7 hit rate.

For its long-short test, the method buys the lowest-ranked 10% of sectors and shorts the highest-ranked 10%. A separate long-only backtest standardizes each sector’s ratio against its own history, using constituent-stock returns over a trailing 100-day window and selecting the lowest 10% monthly. Over 2010 through January 2018, the long-only portfolio is reported to have exceeded an equal-weight sector benchmark. The summary lists excess-return, drawdown, and information-ratio figures, but leaves the long-short return spread incomplete. Results are historical and subject to systemic market risk, factor failure, and model misspecification.

Key ideas

• The absorption ratio measures how much return variation is captured by a small number of orthogonal components.
• Higher ratios are interpreted as greater systemic-risk concentration and weaker diversification.
• The reported signal is negatively related to subsequent sector returns, motivating selection of low-ratio sectors.
• The long-only test uses a 100-day return window and monthly selection of the lowest-ranked 10% of sectors.
• The evidence covers a historical backtest and carries market, factor-failure, and model-specification risks.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.