- A variety of factors affect sector rotation and can determine how strongly the market is impacted.
- Markets experiencing sector rotation can create opportunities for outsized strategies.
- CME Group’s derived blocks can provide the flexibility to execute large-sized trades without disrupting liquidity in the underlying market.
Changes in economic and market cycles can bring about varying interest in different sectors of the market and can thereby lead to sector rotation. When this occurs, market participants have the ability to deploy various tools and strategies to manage risk and protect their portfolios from the ever-changing market conditions.
One such tool is Bloomberg’s Relative Rotation Graph (RRG) function, which effectively identifies sector rotation and illustrates its presence in the markets. The function allows different selection criteria, including benchmark index, region, and time period. The below snapshot illustrates the current sector rotation faced by markets, charting the constituents within the S&P 500 Global Industry Classification Standard (GICS) Level 1 Groups Index where each square data point represents one day, with the remaining tail representing previous daily data. The S&P 500 GICS Level 1 Groups Index classifies companies within the S&P 500 Index into 11 main economic sectors based on their business operations. This classification system provides the ability to manage sector exposure and have a more strategic approach when trading the S&P 500.
The Bloomberg function illustrates each sector’s relative strength and momentum compared to the underlying index. Each quadrant represents different behaviors of momentum (y-axis) versus relative strength (x-axis), with the upper left “Improving” quadrant representing increasing momentum albeit underperformance relative to the benchmark.
Sectors like energy, real estate, and communication services have been experiencing major swings in behavior, with some jumping from a leading to a weakening sector within a matter of days. As illustrated in the relative momentum tool, sector rotation is evident in the current market, and while this divergence can create turmoil in equity markets, it may also create potential opportunities for investors to deploy risk management strategies to counter any ongoing rotation risk.
While using the tool can help identify when sector rotation is occurring, it is up to the investor to determine what kind of strategy they should deploy, which is ultimately based on their current exposure to the rotating market.
One such strategy might be to trade CME Group’s E-mini S&P Select Sector futures, which track the behavior of the S&P 500’s 11 select sector indices. These futures have seen heightened activity in recent months, with average daily volume (ADV) and open interest at elevated levels since the start of the year. Thus far in 2022, combined ADV for all 11 futures products is over 65,000 contracts, a 13% increase from the same time period last year.
While futures can provide various benefits, like margin efficiencies, there are times when market conditions create the opportunity for even larger-sized strategies. When facing sector rotation, market participants may need to move quickly to protect against any outstanding sector exposure. In this instance, CME Group’s derived blocks are one potential option for participants to consider when looking to efficiently express a larger view on the behavior of certain sectors and the overall market.1 Designed to help individuals put up large positions and navigate more uncertain and fast-moving environments, derived blocks are a relevant tool in all types of markets, including one that is experiencing sector rotation.
Derived blocks are a way for market participants to privately negotiate high volume trades, like regular blocks, with the advantage being that the price and quantity of the trade depend on hedging transactions in an eligible related market.
Along with the features of regular blocks, derived blocks provide the ability to place even larger-sized block trades without distorting market pricing and can be an efficient way for block providers to source liquidity and for market participants to try and achieve market-neutral positions. For instance, placing derived blocks using a time weighted average price (TWAP) or volume weighted average price (VWAP) – two eligible pre-defined hedging methods – ensures the block trade is completed without letting market direction skew the desired hedging. Investors can also use derived blocks to take advantage of market opportunities and carry out more complex portfolio strategies, like relative momentum strategies.
Derived blocks are an innovative functionality that have the potential to provide market participants with greater liquidity and execution flexibility, particularly during times of sector rotation. Derived block trades are available to trade for all E-mini S&P Select Sector Index futures in addition to Dow Jones US Real Estate Index futures contracts.
Derived block trades
Privately negotiated derived blocks provide access to Equity Index futures liquidity to execute large trades with a built-in delta hedge.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.