Fama-French Five-Factor Alpha for Sector Rotation

Summary

The document examines whether rolling Fama-French five-factor (FF5) alphas can guide U.S. sector rotation. It compares FF5 with the three-factor model (FF3), using monthly returns for ten U.S. industry portfolios from 1964 to 2014. The rotation signal is each sector’s alpha estimated over a rolling 36-month window: the long-only strategy buys sectors with positive alpha, while a long-short version also sells sectors with negative alpha. A cycle-aware variant shifts to one-month Treasury bills during NBER recessions.

FF5 generally explains sector returns better than FF3, with higher adjusted R-squared values. In the historical tests, the long-only approach outperformed a S&P 500 buy-and-hold benchmark by the reported Sharpe ratio, and the cycle-aware version performed better still; the long-short strategy lagged. Tests using six Select Sector SPDR ETFs from 1999 to 2014 broadly supported the long-only result and estimated break-even trading costs. These findings are historical and sample-dependent: the industry portfolios are not directly investable, the ETF sample is shorter, and the authors describe the strategy as illustrative rather than optimized. The document also does not establish that estimated alpha will persist out of sample.

Key ideas

• Rolling 36-month FF5 alpha is used to rank sectors and set monthly rotation positions.
• The long-only strategy buys sectors with positive alpha, while the long-short version also sells sectors with negative alpha.
• A cycle-aware variant holds one-month Treasury bills during NBER recessions.
• FF5 has higher adjusted explanatory power than FF3, but that statistical improvement does not guarantee better strategy returns.
• Historical tests favor long-only rotation over the benchmark, while the long-short strategy performs poorly.

Tags

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