Industry Rankings in Market Neutral Strategies

In my latest study considering industry-level sentiment factors, I noticed that the total number of company-specific events in the news varied depending on the industry. To probe industry sentiment, I combine 5 different scores from RavenPack that classify each news story as being either positive, negative or neutral.

Considering the sentiment of companies belonging to the S&P500, I construct a set of industry-level sentiment indexes for (1) Oil & Gas, (2) Basic Materials, (3) Industrials, (4) Consumer Goods, (5) Health Care, (6) Consumer Services, (7) Telecommunications, (8) Utilities, (9) Financials, and (10) Technology. Each of these indexes are mapped to an iShares industry ETF for back-testing purposes.

At each month-end, I decide which industries to hold long and short in the following one-month period depending on an industry sentiment delta rank (changes in the normalized indexes).

Figure 1 below depicts the cumulative log-return spread between the top 5 and bottom 5 industries according to a sentiment ranking. As can be observed, the out-of-sample results indicate that a positive spread can be realized taking long and short positions in the top and bottom ranked industries according to sentiment.

Figure 1: Cumulative industry return spread covering the out-of-sample period May 2005 through December 2009 for the top 5 and bottom 5 ranked industries. The sentiment indexes have been constructed based on a 90 day trailing window, and a monthly industry rank was made based on the monthly index delta.

Over the back-testing period, the strategy yields an Information Ratio of 1.23 with values of 0.92 and 1.53 pre- and post- the market high of the test period in October 2007. In addition, the Hit Ratio reaches about 66% with positive returns in 4 out of 5 years with 2008 being the only year with a small loss.