Sector Rotation & ETFs

Sector rotation is based on the idea that different types of businesses perform better or worse in different stages of an economic cycle. Sectors are groups of stocks that represent companies in similar business lines; for example, electric, gas and water companies are grouped together into the Utilities sector.

Investors using the sector rotation strategy seek to shift the balance in their portfolios to give more weight to sectors they believe will be more profitable at a given time. This is an active management strategy that requires adjustment as the market moves through a business cycle.

Sector Rotation in Practice

For example, say it's nearing the holiday season and analysts are predicting strong retail performance. You also can guess that with the cold weather, people are likely spending more on utilities to heat their homes, and quite possibly, they are spending more on gas as some employers close for the holidays and their employees have the opportunity to travel. If you believe these assumptions to be true, then you might choose to buy stocks or funds representing businesses in the Consumer Cyclical, Utilities and Energy sectors. Your goal would be to hold these securities until they peak, and then sell them as you move on to other securities in other sectors.

This can also be used on a larger scale, drawing from global and domestic economic cycles rather than simply seasonal or calendar-based cycles as in the example above. Some sector investors will closely follow the business cycles identified by the National Bureau of Economic Research, the last of which spanned from December 2007 to June 2009. These cycles are identified by contractions and expansions between significant peaks and troughs in the market.

Sector Rotation with ETFs

Exchange-traded funds (ETFs) are a relatively new way to engage in the sector rotation strategy. Rather than selecting individual stocks yourself, which can get costly when you account for transaction fees, some investors are using sector ETFs to buy a whole sector in a single transaction.

Sector ETFs are groups of stocks in the same sector that trade in a single unit during the market day. Typically, they are designed to track a sector index, so as the index moves up or down, the fund value will as well. ETFs trade like stocks, so they can be actively bought and sold anytime, which helps some investors carry out their sector rotation strategy efficiently.

However, because ETFs track indexes, their goal is to match the index's performance, not outperform it, which can be a downside for many investors. Also, because the ETF contains a set basket of securities (which are reported daily by the fund company), you have less control over exactly which stocks you choose to represent a particular sector.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange-Traded Fund (ETF) carefully before investing. Leveraged and Inverse ETFs may not be suitable for all investors and may increase exposure to volatility through the use of leverage, short sales of securities, derivatives and other complex investment strategies. These funds' performance will likely be significantly different than their benchmark over periods of more than one day, and their performance over time may in fact trend opposite of their benchmark. Investors should monitor these holdings, consistent with their strategies, as frequently as daily. A prospectus contains this and other information about the ETF and should be obtained from the issuer. The prospectus should be read carefully before investing.