3 Sector Rotation Strategies ETF Investors Must Know

by on March 27, 2013 | ETFs Mentioned:

Short-term traders and long-term investors alike have flocked to exchange-traded funds (ETFs) in large part because of the exposure they provide to different segments of the economy, including stock sectors, commodities, bonds, real estate and global markets. Investors can now buy a single ETF providing diversified exposure to a specific area of the global economy, which means strategies that were once reserved mostly for professionals are now accessible to everyone. One such strategy is sector rotation [see also How To Swing Trade ETFs].

Equities often move in patterns, with certain types of stocks performing better in certain economic conditions, and other types of stocks performing better in other types of conditions. There are three general rotation strategies you can use to attempt to capitalize on these patterns [Download 101 ETF Lessons Every Financial Advisor Should Learn].

What’s the Appeal?

Not all securities move together at the same time, or least not with the same magnitude. The business or economic cycle, seasonal or calendar tendencies as well geographic location can cause certain stocks to perform better than others, and which stocks perform the best will change as the cycles progress.

Sector rotation strategies attempt to determine which segments of the global economy are likely to be strongest, and then invest in the ETFs related to those specific markets. ETFs provide easy access to markets that were previously harder to invest in, such as commodities or a diversified basket of stocks from one stock sector. The allure is that, if successfully executed, the investor is always invested in the strongest sectors or ETFs and therefore should see higher returns than a basic diversified buy-and-hold strategy.

In order to realize a profit, however, the investor must sell the once-strong ETF when it begins to weaken, and then purchase another ETF that is expected to perform best over the next several months or years. This is where the drawbacks lie. In real-time trading it is not as easy to pin-point times to buy and sell different sectors as the theory implies. Also, since the investor must actively manage the portfolio, commissions will increase as well as the time dedicated to market analysis. Nonetheless  this approach will likely take up less time than researching multiple individual stocks [try our Free ETF Screener].

Strategy 1: Economic Cycle

The economy moves from full recession to early recovery, to full recovery and back into early recession. This process may take many years to complete, but during this cycle the stock market will also be moving up and down. Stocks generally lead the economy, and therefore the stock will often bottom (and head higher) before the economy begins to pick up, and stocks will top out before the economy begins to slow down [see How To Take Profits And Cut Losses When Trading ETFs].

Since stocks are the primary input, investors can simply watch the overall trend of the S&P 500 to determine which sectors are likely to perform the best.

According to research by John Murphy, discussed in his book “Intermarket Analysis, certain sectors perform the best during different phases of the market trend.

When the market is at a bottom, Consumer Discretionary stocks are usually the first to turn higher; investors can trade this sector using the Consumer Discretionary Select Sector SPDR ETF (XLY). This upturn is generally followed by an uptick in Technology (XLK), then Industrials (XLI) and then Basic Materials (XLB). When the Energy sector (XLE) is the top performer, it is often a sign the stock market is topping out.

Buying interest then typically moves into the Staples (XLP) sector and Healthcare (XLV) as the broader market begins to decline. As the market gets weaker, Utilities (XLU) generally outperform, and finally money begins to flow into Financials (XLF)–when this occurs it is usually a sign that the broader market is close to a bottom.

This pattern provides a general outline of which sectors will perform best, and in what order. The strategy is to invest in the strongest sector ETFs, then when momentum begins to wane, exit the position and move into the sector that is showing the most potential. The order may change during any given cycle, so focus on actual sector performance and not just this historical tendency [see The 5 Most Important Chart Patterns For ETF Traders].

During a bear market it is important to remember that all the sectors may decline. Even if one sector is performing better than others, be aware that the sector ETF may still fall, resulting in losses.

Strategy 2: Seasonal

During the calendar year investors can also rotate into sectors that benefit from yearly events.

“Driving season” positively impacts the Energy industry. During the summer months more travel and driving occurs, which may lift prices at the pump and increase margins for refiners. Demand increases may help those in the Exploration and Production side of the business. To take advantage, buy the Energy Select Sector SPDR (XLE) or the SPDR Oil & Gas Exploration and Production (XOP) if the sector begins to creep up in anticipation of the driving season. Exit the sector when momentum begins to wane and the season winds down.

By that time, there are other sectors to look at. As September approaches, retailers generally see a jump in sales due to students returning to school. This sector is tradable via the SPDR S&P Retail ETF (XRT). As shopping ramps up during the Christmas season, this sector also generally sees buying interest, but to what magnitude is determined by the overall consensus of whether it will be a busy or quiet shopping season [see 17 ETFs For Day Traders].

Overall market conditions may overshadow such tendencies. If the broader market–gauged by the S&P 500–is in decline, the relative strong performance of these sectors during these times of year may not overcome the general selling pressure. Therefore, wait for the sectors to show strength in anticipation of these points on the calendar before buying, instead of simply assuming the sector will perform well.

Strategy 3: Geographic

Looking to markets outside your home country can be a lucrative strategy, as there are often global markets that may be seeing comparatively stronger growth. Before ETFs, investing in these global markets was trickier, but with ETFs you can simply monitor which country ETFs are performing the best, and buy those funds. As momentum begins to wane, exit the trade and look for another country that is performing better [try our Free ETF Country Exposure Tool].

During 2012, the MSCI Singapore Index Fund (EWS) performed well, gaining close to 26% relative to the SPDR S&P 500 (SPY)–a gain of roughly 13% on a price performance basis. The MSCI Mexico Index Fund (EWW) performed even better, racking up a price gain of 31%.

Investors can also invest in a category, such as “emerging markets.” These markets are in their growth phase, and while the ups and downs can be volatile, strong trends can bring big rewards. To invest in a basket of emerging countries, look to the popular FTSE Emerging Markets ETF (VWO) or the MSCI Emerging Markets Index Fund (EEM): see also Complete List of Emerging Markets Equities ETFs.

The Bottom Line

Whether you are looking to capitalize on economic cycles, seasonal tendencies or geographic trends, ETFs provide a simple and direct way to accomplish this through a rotation strategy. As with any strategy there are risks, and it is important to gather information on the markets and ETFs you are investing in before making your purchase. Sector rotation strategies generally position the investor in the strongest segments of the global economy, but trends change. When the sector you are in starts to turn, it is time to exit the position and look for another segment that is performing better. This may incur commissions and some active management of the portfolio, but if done correctly, the returns should more than compensate.

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Disclosure: No positions at time of writing.