What is Sector Rotation? (Investment Rotation)
Sector rotation is an advanced investment strategy that involves strategically shifting money from stocks in one industry to another.
April 6, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
Investing is a key component of building wealth and reaching financial goals. And as investors, we all want to earn the highest returns possible.
Some investors choose to employ advanced strategies to try to earn higher returns. One such strategy is called sector rotation.
But what is sector rotation exactly? And is it worth exploring for your own portfolio?
What is sector rotation?
Sector rotation is an investment strategy that involves rotating investment money from one sector (industry) to another.
For example, it could mean shifting from technology stocks to utility stocks.
It doesn’t have to be all-or-nothing, however.
Consider an investor who has 50% of their assets in growth stocks, 10% in utility stocks, and 40% in bonds. They might decide to shift to a 40%, 20%, 40% split, by moving 10% of assets from growth stocks to utility stocks.
You could earn higher returns. Theoretically, you could earn higher returns if you successfully employ a sector rotation strategy. Keep in mind, it can be difficult to time correctly.
You could preserve capital. Another focus of sector rotation strategy is to avoid heavy losses in market downturns. For example, skilled investors (and lucky investors) may be able to shift to more conservative industries shortly before a market crash.
You could be wrong. You could decide to shift from tech stocks to utilities because you feel a correction is coming. But tech stocks could continue to outperform, leading to poor performance for your portfolio.
You could be right, but too early. Even if you are correct in your theory, you could rotate your assets too early. This is one reason why sector rotation is so tricky.
You could underperform the market.Investors who employ active trading strategies like sector rotation often seek to earn higher returns than they would in passive investment strategies, like index funds. But if you time things wrong, you could end up earning lower returns than if you had simply remained invested and left your portfolio on auto-pilot.
Sector rotation strategy
At its most simple, sector rotation simply means shifting assets from one sector to another.
However, there are specific sector rotation strategies that some investors use.
Often, sector rotation involves trying to time the market and business cycles.
Sector rotation investors seek to profit by timing changes in the business cycle and adjusting their portfolios accordingly.
For example, when the economy is strong, investors may pile into technology growth stocks. But as the economy starts to shift and investors see there may be a recession coming, “safer” industry stocks like healthcare companies and utilities may become more attractive.
Sector rotation and the “market cycle”
Many investors seek to earn higher returns by timing what’s known as the “market cycle.”
The market cycle is related to the business cycle. The business cycle is a way to measure periods of economic expansion and economic recession.
Generally speaking, the economy expands until a recession (contraction) begins. The economy then slows as the recession continues. Eventually, a recovery begins, leading to a gradual expansion and another period of economic prosperity. This cycle has repeated itself throughout modern history.
The market cycle is essentially the market’s attempt to predict the business cycle ahead of time. For example, the stock market may react and try to predict a recession before that recession actually begins.
Markets tend to move in four key phases:
Accumulation phase: This comes after the stock market has bottomed out. Market sentiment is still negative, and the economy is likely still in recession. But valuations are attractive, and long-term investors during this phase are usually well rewarded.
Mark-up phase: This comes when the market has been stable for a while and prices are beginning to move higher. Towards the end of this phase, valuations can climb above historical averages.
Distribution phase: This comes as market sentiment starts to shift from overwhelmingly positive, to more mixed. Sellers begin to dominate the market, and prices can be volatile within a certain range.
Mark-down phase: This comes as heavy selling begins, and prices decline significantly.
Stock sector rotation experts may attempt to time phases of the market cycle to improve their returns. For example, they may sell technology assets during what they believe is the beginning of the distribution phase, and then re-buy those assets in the accumulation phase.
Should I attempt sector rotation with my own portfolio?
You are free to make your own investment decisions. If you want personalized advice, it may be worthwhile to discuss your strategy with a financial advisor.
Keep in mind that sector rotation is an advanced strategy and it’s difficult to execute well.
It is always difficult to time the stock market and sector rotation is just a form of market timing.
It’s so difficult, in fact, that most hedge funds underperform the overall stock market.
In a famous wager, billionaire investor Warren Buffet bet $1 million that the S&P 500, an index of 500 large companies in America, would outperform a selection of hedge funds over a 10-year period.
Buffet won his bet — and the results weren’t even close.
The S&P 500 returned a total of 125.8% over the time period (8.5% per year)
The best-performing basket of hedge funds returned 87.7% (6.5% per year)
The worst-performing basket of hedge funds returned just 2.8% (0.3% per year)
These results illustrate that it’s very difficult to beat the stock market,even if you actively trade. These hedge funds likely made thousands of buy and sell decisions, and likely employed sector rotation, rebalancing, leveraging, options trading and many more advanced strategies.
And the result? A buy-and-hold portfolio of a single passively managed fund beat hedge funds handily.
Keep in mind that hedge funds are professional investment funds that manage billions of dollars and employ teams of highly skilled finance professionals.
The majority of investors will be better off keeping things simple. Slow and steady wins the race when it comes to your financial goals.
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