Sector Rotation

TL;DR: Sector rotation means shifting your investments towards sectors you expect to do better, depending on the phase of the economy. The idea is logical, but the timing is very hard and every switch costs money. For many investors a broadly diversified portfolio is simpler.

Step-by-step guide

1. Learn which sectors exist and what they do.
2. Look at how the economy is doing: growth, interest rates, inflation, unemployment.
3. Find out which sectors have done better than the broad market in recent months.
4. Ask why: does it fit the economic phase, or is there another cause?
5. Decide the most you want in any one sector, to spread your risk.
6. Work out the cost of a switch: transaction fees, spread and possibly tax.
7. Review regularly and be willing to admit you were wrong.
8. Consider whether a broadly diversified fund is simpler for you and better suited to your goal.

What is sector rotation?

The stock market is divided into sectors, for example banks, technology, energy, healthcare, food and utilities. Sectors do not always do well at the same time. Sector rotation tries to play on that: you shift your money towards sectors you expect to do better, and away from sectors you expect to do worse.

The economic cycle

The economy moves in waves: growth, slowdown, contraction and recovery. The idea of sector rotation is that sectors perform differently in each phase. This is a simplified picture:

• Recovery after a contraction: interest rates are low and companies and consumers start spending more again. Banks and companies that depend on consumer spending sometimes do better.
• Growth: companies invest and revenue rises. Technology and industry sometimes do better.
• Late phase with high inflation and rising rates: commodities and energy sometimes do better.
• Contraction: people keep buying what they need, such as food, healthcare and energy. Such defensive sectors sometimes fall less.

Note the word ‘sometimes’. This pattern does not hold in every cycle. Every period has its own causes: a pandemic, an energy crisis, a technological shift or a rate decision can turn the picture upside down.

Why it is hard

• Recognising the phase: you often only know afterwards which phase the economy was in.
• The market looks ahead: the price often moves before the economic figures change.
• Indicators contradict each other: interest rates, unemployment, purchasing managers’ indices and consumer confidence do not always point the same way.

Relative strength

Besides economic theory, you can look at what sectors are doing now. Relative strength compares a sector with the broad market. You divide the price of a sector fund by the price of a broad fund. If that ratio rises, the sector is doing better than the market.

Worked example

Suppose a sector ETF is at €50 and a broad ETF is at €200. The ratio is 50 / 200 = 0.25. Three months later the sector ETF is at €55 (+10%) and the broad ETF at €210 (+5%). The ratio is then 55 / 210 = 0.2619. That ratio rose by about 4.8% ((0.2619 / 0.25) - 1). So the sector did better than the market.

That describes the past. It does not say this will continue. Sectors that did well for a long time may also have become expensive.

Sector rotation in practice

Investing in sectors

Many investors use ETFs (exchange-traded funds) that track a sector. With one order you buy a basket of shares from that sector. For investors in the EU, different rules apply than in the US: some US ETFs may not be sold to retail investors in the EU because the key information document (KID) is missing. So look at ETFs that are tradable in Europe, such as UCITS funds on Euronext, and read each fund’s KID.

Worked example: the cost of a switch

Suppose you have €10,000 invested and you switch €1,000 from sector A to sector B. You pay €4 per order, so €4 to sell and €4 to buy. That is €8 per switch. Do this 3 times a year and it is €24 a year in order costs, before counting the spread and possibly tax. That looks small, but it must first be earned back before the rotation adds anything. With small amounts or many switches it adds up quickly.

Diversification still matters

A sector ETF is less diversified than a broad ETF. It can swing more. So do not put all your money in one sector. Read more about diversifying your portfolio.

Alternative: stay diversified

A broadly diversified fund holds all sectors. It takes little time and few costs, and you do not need to predict the cycle. Sector rotation may suit some investors as an addition, but it is no replacement for diversification and no guarantee of a better result. Test any rules first with a backtest, and be aware of limitations such as overfitting.

Investing involves risk: you can lose all or part of your money. Past performance is no guarantee of future results. This tutorial is information, not investment advice.