Using ETFs as Part of a Sector Rotation Strategy

Focus on the Strongest Sectors and Industries for Superior Returns

Dec 22, 2008

Too often, investors own stocks moving against the grain. A portfolio is easier to manage, and considerably more profitable, when the wind is at an investor's back.

All investors want to improve their returns, but too many of them just don't know how. Nearly all the lessons they've been taught by books, brokers, and broadcasts might work in theory, but in the real world, they just don't lead to investing success. Sector rotation is one of those ideas that's actually not taught in those books, yet it can be a highly effective tool.

Of course, sector and industry ETFs (exchange-traded funds) are one very simple way to capitalize on this relatively simple investing premise.

What is Sector Rotation?

Sector rotation is a very reasonable but effective 'strength-finding' strategy any investor can employ with a minimal amount of effort.

The idea is actually pretty simple... avoid weak sectors (or short-sell them), or buy the strongest sectors. With a sector rotation tactic in place, investors will generally hold stocks in five to six sectors--industries expected to outperform the overall market.

Rarely will an investor be exactly right, but if four of those six sectors beat the market -- and the investor avoids the worst one or two sectors at the time -- the results are surprisingly superior returns.

Is a Sector Rotation Strategy Worth the Trouble?

The difference in performance between the leading sector and the lagging sector for any given year is wider than most anyone realizes.

The majority of investors guess the disparity is 10%, meaning if the leading sector gains 25% over a twelve-month period, then the laggard gains 15%. The difference between the two is 10%. Some investors guess the disparity is 5%, while others think it's 15%. The average guess, however, is about 10%. None of those guesses are close though.

The reality is, the difference between the top sector and the bottom sector in the average year is actually about 30%. Avoiding the bottom two sectors and 'doubling-up' on the top two sectors can effectively double the market's average return for that portfolio owner. So yes, even capturing part of that disparity is worth the effort.

How Can the Strategy be Employed in an Actual Portfolio?

Exchange-traded funds -- or ETFs -- are the easiest way to capture the positive effects of sector rotation. They're a basket of stocks in a certain sector, so there's no company-specific risk. There are even industry-specific ETFs, if a trader wanted to be slightly more focused and increase his or her potential return. Similarly, there are a variety of country-based ETFs available.

Tools to Spot Sector Rotation

The StockCharts.com tool spots the relative performance of all sectors for any point in time, and any timeframe. The sliding scale at the bottom of the chart is adjustable. The chart can even be customized with specific ETFs.

The SmartMoney tool is a different way of looking at relative performance....using bars instead of plotted lines. There's no visual overlay like there is with the StockCharts.com tool, nor can the 'start' date be moved to any point in time. And, a trader's own tickers can't be plotted. However, it is possible to 'drill down' into individual industries, and then even into individual stocks. This considerably greater detail is useful if trying to pick a specific stock.

The copyright of the article Using ETFs as Part of a Sector Rotation Strategy in Funds Investing is owned by James Brumley. Permission to republish Using ETFs as Part of a Sector Rotation Strategy in print or online must be granted by the author in writing.