Until the advent of the sector-based exchange-traded funds (ETFs), implementing a sector rotation strategy could only be well-executed by large institutional investors. Now with ETFs, individual investors can easily and cheaply implement this strategy.

SEE: Exchange-Traded Funds

What Is a Sector Rotation Strategy?
One way of defining a stock's risk is by breaking it down by: stock-specific risk, market risk and industry risk. Just as most stocks tend to move based on the underlying factors that drive the overall market, stocks in a similar industry will tend to move based on the underlying factors that drive that industry. For example, when oil prices are rising, most stocks in oil-producing companies will follow suit. Similarly, when the subprime mortgage market collapsed, it impacted most financial stocks, as financial companies were owners or originators of those loans.

A sector rotation approach is similar to tactical asset allocation, where investors will allocate their funds to those asset classes which they believe will outperform in the relative short term. In sector rotation, rather than individual asset classes, the investors will allocate funds to different sectors depending on their short-term views. The investor will overweight those sectors that he or she believes will outperform and underweight those he or she believes will underperform.

This sector rotation (or sector allocation strategy) is a top-down strategy. In developing a strategy, an investor identifies key factors within each sector to help predict the future relative performance of the sector, and then the investor will overweight or underweight the sectors based on the current status of those factors. These factors could include:

In the analysis, a long history of data over a number of different economic and market cycles is usually required to identify the key factors and leading indicators that can predict relative performance.

Selecting the Right Family of ETFs
The introduction of sector ETFs has allowed the individual investor to easily implement sector rotation strategies that were not practical before. There are three considerations when selecting the right family of sector ETFs. The first is that the ETF should contain the full spectrum of sectors and stocks that make up an index. Secondly, the index should be broadly based - representative of the overall economy. Lastly, there should be sufficient history on the underlying sectors to be able to carry out the long-term due diligence required to uncover the key factors.

Market-Weighted Sector ETFs
Market-weighted sector ETFs are based on the traditional market capitalization indexes and their underlying sectors. The two largest families of sector ETFs are the Barclays iShares Dow Jones sector ETFs and the State Street Global Advisors sector ETFs. Each covers the full expanse of stocks and sectors that are constituents in their respective indexes.

Barclays iShares Dow Jones sector ETFs use the Dow Jones U.S. index as the underlying index. This index is a market capitalization index designed to represent 95% of the U.S.equity market. The iShares uses the Industrial Classification Benchmark (ICB) system to determine the composition of each sector and sub-sector. ETFs are available for each of the 10 main sector categories.

State Street Select Sector SPDRs use the S&P 500 as the underlying index. It is a market capitalization index representing about 75% of the U.S. equity market. The Select Sector ETFs use the Global Industry Classification Standard (GICS) to determine the composition of each sector. Although there are 10 sectors, there are only nine ETFs, as the information technology and telecommunications sectors are combined to create one "technology" ETF.

Both the GICS and ICB are biased toward large-cap stocks. Since economic analysis plays a big part in the sector rotation strategy, it is important that the underlying sectors are representative of the broad economy. Using either of the two will provide excellent exposure to the overall U.S. economy and the sectors in it. The iShares ETFs are more comprehensive, but SPDRs have a longer track record.

Equal-Weighted Sector ETFs
Equal weight means that all stocks have a similar weighting in the index, regardless of the size of the company. In a market-weighted index, the large-cap stocks have a greater impact than the small-cap stocks. Therefore, an equal-weighted index will tend to outperform a market-weighted index when small caps are out-performing large caps.

The Rydex S&P 500 Equal Weight sector ETFs are based on the S&P 500 index and the GICS standard. An equal-weighted index is more biased towards small stocks and might not be representative of the overall economy. It is important that the sectors not only represent the entire economy but are also in similar proportion to the index. For example, if the energy sector is 15% of the economy, a 15% weight in the index would demonstrate that it is close to the same representation. An equal-weighted index would overweight small-cap stocks and underweight large-cap stocks. Since large-cap stocks are more representative of the economy, equal-weighted ETFs might not be the best choice when implementing a sector rotation strategy.

Fundamentally Weighted Sector ETFs
A fundamentally weighted index is a relatively new addition to the ETF landscape. Rather than being based on market capitalization or equal weight, the weighting of each stock in the index will be based on the underlying fundamentals. PowerShares has created a series of sector ETFs based on a fundamentally weighted sector index, the FSTE RAFI US 1000 Index. The factors that determine the fundamental value are: sales, cash flow, book value and dividend. Companies that are deemed the largest by those underlying factors will have the largest weights in the index.

There are nine PowerShares FTSE RAFI sector ETFs. The ICB is used to determine the composition of each sector. Information technology and telecommunications have been combined into one sector.

Market weight indexes tend to give greater weightings to overvalued stocks (stocks that have appreciated to high market caps) compared to the underlying fundamentals. This might overstate the importance of those stocks, and their corresponding sector, within the overall economy. Consequently, a fundamentally weighted index might be more closely aligned to the overall economy since the weights of the individual companies are based on size of the company, not just the market cap. Unfortunately, this index does not have the extensive history necessary to determine the underlying factors that drive sector performance.

Sector Rotation Using Only Sector ETF
In developing and implementing a system for sector ETF investment, it is important to select an appropriate benchmark index. Once the index is selected, an investor must understand how the index and the underlying sectors are constructed, as well as how the constituent stocks are chosen. Using the S&P 500 would be a good choice, not only because it has broad large-cap representation of the market, but also because it has a long history.

To demonstrate a simple strategy, let's examine the State Street Select Sector SPDRs ETF, which uses the S&P 500 as the base index. We'll assume a $100,000 investment in the strategy. In the table below, we show the sectors, the symbol of the appropriate ETF, the current sector weight, as well as the amount invested in each ETF to implement the strategy.

Example 1: Sector Rotation Strategy Apr. 30, 2008
-- ETF Symbol S&P 500 Wt. % Over/Under Target Amount
Consumer Discretionary XLY 8.6 0.0 8.6 8,600
Consumer Staples XLP 10.5 0.0 10.5 10,500
Energy XLE 14.0 3.0 17.0 17,000
Financials XLF 17.1 -3.0 14.1 14,100
Healthcare XLV 11.3 2.0 13.3 13,300
Industrials XLI 11.8 0.6 12.4 12,400
Materials XLB 3.7 3.0 6.7 6,700
Technology XLK 19.4 -2.0 17.4 17,400
Utilities XLU 3.6 -3.6 0.0 0

The strategy is to overweight energy, healthcare, industrials and the materials sectors. Financials, technology and utilities will underweight the index, and consumer discretionary and consumer staples will be market weight. With $100,000 to invest, a portfolio containing eight sector ETFs would be easy to implement. It would, however, not be able to exactly match the percentages as it might if sector mutual funds were used. For example, if the energy sector ETF, XLE, trades at $87.70, then it would take 193.8 shares. Rounding would mean buying 190 shares (or $16,663) representing 16.67% of the total portfolio.

Sector Rotation Using Core and Satellite Positions
Using a core and satellite approach could implement the same strategy as above. In the example below, the portfolio has the same sector weights as in the first example. In this case, $50,000 is invested in the S&P 500 using the SPY ETF to represent the core, and then additional sector ETFs are purchased to reach the target amount. For example, let's say you want to achieve a weight of 17% invested in the S&P 500 energy sector. If the SPY ETF has a $7,000 exposure in the energy sector (14% x $50,000), then $10,000 of XLE will have to be purchased to make up the balance. For utilities, since we did not want any more exposure, $1,800 of the XLU would be sold short.

Example 2: Sector Rotation Strategy Using Core/Satellite
-- ETF Symbol Target Amount $50,000 SPY Sector ETF
Consumer Discretionary XLY 8,600 4,300 4,300
Consumer Staples XLP 10,500 5,250 5,250
Energy XLE 17,000 7,000 10,000
Financials XLF 14,100 8,550 5,550
Healthcare XLV 13,300 5,650 7,650
Industrials XLI 12,400 5,900 6,500
Materials XLB 6,700 1,850 4,850
Technology XLK 17,400 9,700 7,700
Utilities XLU 0 1,800 -1,800

In this example, there is no major advantage over using just the sector ETFs. However, there is a small cost advantage as the SPY ETF has an expense ratio of only 0.09% versus 0.27% for the sector ETFs. In the first case the annual management fees would be about $270, and in the second case it would be about $180.

Taking a specific sector bet, the core and satellite approach will be simpler and more cost effective. As an example, assume that you want your portfolio to overweight the energy sector by 6%, and have the rest in the balance of the S&P 500. Using $100,000, a total of $20,000 invested should be invested in the energy sector.

Investing $93,000 in the SPY ETF and $7,000 in XLE will result in a 20% weight in energy ($93,000 x 0.14 = $13,020 coming from the SPY). The net result is a portfolio that is 20% energy sector and all the other sectors are proportionally underweight. This portfolio will have only two securities versus nine if the sector ETFs were used and it would be cheaper and simpler to implement.

The Bottom Line
The advent of the sector ETF allows individuals to easily implement sector rotation or sector allocation strategies. It is important to select the right family of ETFs with broad representation and a good history to implement the strategy. Although one can build a portfolio by just using the sector ETFs, a core and satellite approach can accomplish the same result and in some cases it is a simpler and cheaper solution.

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