What Is Sector Rotation, and Does It Work?
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Sector rotation involves moving money between sectors in an effort to keep it in the best-performing sectors at all times.
Which sectors outperform at which times? Depending on who you ask, you’re likely to get a slightly different answer, but there are some common theories.
Sector rotation ETFs like XLSR and SECT have underperformed the S&P 500 in the last year.
The stock market is commonly divided into 11 sectors: energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, technology, communication services, utilities and real estate.
Which sectors do well at which times? Sector rotation is an investment strategy that tries to find out – and profit from that information.
What is sector rotation?
Sector rotation is an active investing strategy that involves moving money between sectors in an effort to keep it in the best-performing sectors at all times. It often uses exchange-traded funds (ETFs) that track specific sectors — such as tech ETFs or energy ETFs.
Sector-rotating investors often divide the business cycle — the neverending sequence of economic booms and busts — into four phases that can be bucketed as follows: recession, bull market, peak and bear market. The idea is that specific sectors outperform the others at specific points in the cycle.
Which sectors outperform at which times? Depending on who you ask, you’re likely to get a slightly different answer, and there’s some disagreement on whether one particular sector is a better option in the tail end of one phase or the beginning of another — but the table below highlights some popular theories.
Stage of economic cycle | Sectors that may outperform |
|---|---|
Recession | Technology |
Bull market | Industrials, materials, energy |
Peak | Communication services, financials |
Bear market | Health care, utilities |
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Sector rotation ETFs
Some ETF issuers take the guesswork out of sector rotation for you, by doing it themselves within a sector rotation ETF. The SPDR SSGA US Sector Rotation ETF (XLSR) and the Main Sector Rotation ETF (SECT) are examples.
Both use their own separate methodologies, but they have one thing in common — they’ve both underperformed the S&P 500 index over the last year.
» Interested in ETFs? Check out the best ETFs by one-year performance.
Does sector rotation work?
The fact that sector rotation ETFs underperform the S&P 500 is not the only mark against sector rotation strategies. In a widely-cited 2007 paper, economists at Massey University in New Zealand examined US stock returns between 1948 and 2006. They found that sector rotation strategies tend to underperform simpler strategies.
“We conclude that, contrary to conventional market wisdom, rotating sectors over business-cycles is unlikely to be an optimal investment strategy and question the widespread acceptance of sector rotation as a strategy that provides investors with relative outperformance,” the researchers wrote .
» Speaking of research: Brush up on how to research stocks.
So sector rotation may not be a silver bullet, at least with the sector rotation methods we have today. It’s possible that some investor or economist could discover an easy and reliable sector rotation method in the future, but they haven’t figured one out yet.
Until then, investors may find it helpful to take one page from the book of sector rotation: Investing through ETFs. This is one easy way to provide investment diversification to a portfolio.
» MORE: Best online brokers for ETFs
Neither the author nor editor owned positions in the aforementioned investments at the time of publication.
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