How to Spot a Style Rotation with ETFs

by on June 3, 2014

Seasoned market veterans know the importance of the business cycle and how it influences investors’ sector preferences depending on the prevailing and expected economic conditions. The proliferation of ETFs has made the application of sector rotation strategies easier for self-directed investors given the unparalleled liquidity, ease-of-use, and cost efficiency that is associated with these financial instruments. 

ETFs have also made their way onto countless radar screens because of the valuable insights that can be extracted from monitoring the performance of broad-based funds representative of entire asset classes; for example, we recently delved into the topic of How to Spot a Sector Rotation with ETFs

Digging deeper into the ETF universe, we see that the sheer variety of offerings makes all sorts of analysis possible that was once accessible only by more sophisticated investors. Specifically, we’re alluding to the idea of using ETFs to gauge market cap and investment style preferences; this sort of analysis involves a comparison that spans across large, mid, and small cap equities, as well as growth- and value-focused strategies. 

Below we’ve outlined a simple framework for such an analysis along with a real life example that can be adapted to virtually any scenario.

Ask the Right Questions

Style rotation is all about being invested in the right corners of the market that are poised to continue outperforming, as well as identifying those that are on the cusp of taking leadership. In an effort to succeed in both of these endeavors, investors must start by asking the right question that gives them insights about the current environment: who are the current market leaders?

Second, investors should also keep in mind that rotations more often than not take place during broad market corrections. Because of this, it’s important to understand any fundamental drivers behind the pullback, which means answering the question: what led to this particular market decline?

Lastly, one must consider how the fundamental reasons behind the correction at hand have influenced investors’ expectations going forward: in other words, this means asking the question, who are the new leaders? 

Lessons Learned from the January 2014 Sell-Off

Let’s ask the three questions from above in the context of the broad-based correction that swept across Wall Street in late January of 2014. Remember, our goal here is to identify any preference changes regarding market cap (large, mid, or small) and/or style (growth or value) that investors could have taken advantage of – this example assumes perfect hindsight for explanation purposes [see also 3 Contrarian Indicators ETF Investors Must Know]. 

First, let’s determine the market leaders at the time prior to the correction. To do this, we’re going to look at the returns from the bottom of the previous major pullback through the peak in January just before the plunge; in the chart below, the Before returns (blue columns) span from 6/24/2013 through 1/22/2014. Next, we want to analyze any fundamental drivers behind the pullback. Lastly, we want to confirm any rotation that may have taken place by comparing the returns of the same ETFs following the correction; in the chart below, the After returns (red columns) span from 2/5/2014 through 5/23/2014. Consider the findings below:

Now let’s re-address our three questions:

  • Leading up to the correction, it’s quite clear that investors had an appetite for risk; this is evidenced by the Small Cap ETF (IJR) outperforming its broad-based counterparts, the Mid Cap (MDY) and Large Cap (SPY) ETFs, by a considerable margin. Investors’ appetite for risk is further showcased when we consider that growth-focused strategies within each market cap level, including  RPG, RFG, and RZG, were the top performing ones compared to their respective broad-based and value-focused counterparts.
  • The reason for this pullback is hard to pinpoint, seeing as how there were no major fundamental developments that took place at this time, aside from worrisome China manufacturing data, which reignited fears over a global economic slowdown. As such, in light of the U.S. stock market’s impressive run-up at the time, this correction was likely a result of mounting profit-taking pressures rather than a fundamental catalyst.
  • There was indeed a style rotation during this pullback, one that favored larger, value equities over smaller, growth ones. This is evidenced by the change in leadership from small cap growth stocks to large cap value stocks; notice how large caps broadly outperformed their smaller cap counterparts following the pullback. Furthermore, investors’ declining appetite for risk is showcased when we consider that value-focused strategies within each market cap level, including  RPVRFV, and RZV, were the top performing ones compared to their respective broad-based and growth-focused counterparts.

Let’s put this all into context. Prior to the January sell-off, investors favored smaller, growth stocks in light of encouraging economic prospects. As the bull run persisted on Wall Street, however, investors were quick to scale back on their risk appetites in light of the stellar returns at hand; the style rotation that followed confirms this, seeing as how large cap stocks outperformed smaller ones and value equities came into favor more so than growth ones. 

The Bottom Line

Style rotation refers to favorably positioning your portfolio whenever investors’ expectations regarding economic conditions change; there are times when a fundamental catalyst warns of an impending turn in the business cycle, however, it is also possible for investors’ preferences to change simply in response to recent price action on Wall Street. By being aware of the prevailing market cap and style preferences at hand, investors can more favorably fine-tune their portfolios for the coming months. Remember that a successful investment strategy requires diligent research and disciplined execution in addition to constantly monitoring the prevailing economic environment. 

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Disclosure: No positions at time of writing.