Many investors are interested in investing and diversifying their portfolio in various global and local sectors, but are often unsure of where to start. Sector rotation is a strategy used by investors whereby they hold an overweight position in strong sectors and underweight positions in weaker sectors. Exchange-traded funds (ETFs) that concentrate on specific industry sectors offer investors a straightforward way to participate in the rotation of an industry sector. ETFs also allow an investor to take advantage of the investment opportunities in many industry groups throughout the world. (To learn the basics of sector rotation, check out Sector Rotation: The Essentials.)

Tutorial: Exchange-Traded Fund Investing

In this article, we'll show you three different sector rotation strategies and identify why ETFs help smooth each style's path.

Why Do Investors Choose Sector Rotation?

As the economy moves forward, different sectors of the economy tend to perform better than others. The performance of these sectors can be a factor of the stage of the business cycle, the calendar or their geographic location.

Investors seeking to beat the market may spend countless hours reading through articles and research reports. Using a top-down approach, they might develop a basic forecast of the economy, followed by an assessment of which industries hold the most promise. Then the real work begins - trying to find the right companies to buy.

A simpler alternative is to use ETFs that focus on specific sectors. Sector rotation takes advantage of economic cycles by investing in the sectors that are rising and avoiding the ones that are falling. (Keep reading about this in The Ups And Downs of Investing in Cyclical Stocks.)

Sector rotation is a blend of active management and long-term investing: active in that investors need to do some homework to select the sectors they expect to perform well; long-term in that you can hold some sectors for years.

Markets tend to anticipate the sectors that will perform best, often three to six months before the business cycle starts up. This requires more homework than just buying and holding stocks or mutual funds, but less than is required to trade individual stocks. The key is to always buy into a sector that is about to come into favor while selling the sector that has reached its peak.

Investors might consider three sector rotation strategies for their portfolios. The most well-known strategy follows the normal economic cycle. The second strategy follows the calendar, while the third focuses on geographic issues.

Economic-Cycle Strategy

Sam Stovall of Standard & Poor's describes a sector rotation strategy that assumes the economy follows a well-defined economic cycle as defined by the National Bureau of Economic Research (NBER). His theory asserts that different industry sectors perform better at various stages of the economic cycle. The S&P sectors are matched to each stage of the business cycle. Each sector follows its cycle as dictated by the stage of the economy. Investors should buy into the next sector that is about to experience a move up. When a sector reaches the peak of its move as defined by the economic cycle, investors should sell that ETF sector. Using this strategy, an investor may be invested in several different sectors at the same time as they rotate from one sector to another - all directed by the stage of the economic cycles.

The major problem with this strategy is that the economy usually does not follow the economic cycle exactly as defined. Even economists cannot always agree on the trend of the economy. It is important to note that misjudging the stage of the business cycle might lead to losses, rather than gains.

Calendar Strategy

The calendar strategy takes advantage of those sectors that tend to do well during specific times of the year. The midsummer period before students go back to school often creates additional sales opportunities for retailers. Also, the Christmas holiday often provides retailers with additional sales and travel-related opportunities. ETFs that focus on the retailers who benefit from these events should do well during these periods.

There are many examples of cycle-specific consumer events, but an easy one to classify is the summer driving season. People in the northern hemisphere tend to drive their cars more during the summer months. This increases the demand for gasoline and diesel, creating opportunities for oil refiners. Any ETF that has a significant portion of its holdings in companies that refine oil may benefit. However, as the season winds down, so will the profits of that related sector's ETFs.

Geographic Strategy

The third sector rotation perspective investors can employ is to select ETFs that take advantage of potential gains in one or more of the global economies. Maybe a country or region is benefiting from the demand for the products they produce. Or perhaps the economy of a country is growing faster than the rest of the world. ETFs may be available that offer investors an opportunity to play such trends without having to buy individual stocks.

Managing Risks

Like any investment, it is important to understand the risks of the sector rotation strategy and the corresponding ETFs before committing capital. By investing in several different sectors at the same time, weighted according to your expectations of future performance, you can create a more diversified portfolio that helps to reduce the risk of being wrong about any particular investment. An ETF strategy naturally spreads stock selection risk across all companies in the ETF. However, investors should be careful they do not create unwanted concentration in any one sector, especially when using a blend of the economic-cycle, calendar and geographic strategies.

With so many ETFs available to investors, it is important to understand the investing strategy and portfolio makeup of the ETF before committing capital. Moreover, lightly traded ETFs pose additional risk in that they may be difficult to sell quickly if there is no underlying bid for the shares.

The Bottom Line

By investing in a diversified set of ETFs, an investor is positioned to take advantage of an uptrend in certain sectors while reducing the risk of losses due to exposure to high-risk stocks. In addition, by selling a portion of your holdings in sectors that are at the peak of their cycle and reinvesting in those sectors that are expected to perform well in the next few months, you are following a disciplined investment strategy. (See also: Disciplined Strategy Key To High Returns.)

A sector rotation strategy that uses ETFs provides investors with an optimal way to enhance the performance of their portfolio and increase diversification. Just be sure to assess the risks in each ETF and strategy before committing your money.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.