What Is Sector Rotation?

The term sector rotation refers to the act of shifting investment assets from one sector of the economy to another. Sector rotation involves using the proceeds from the sale of securities related to a particular investment sector for the purchase of securities in another sector. This strategy is used as a way to capture returns from market cycles and to diversify holdings over a specified holding period.

Key Takeaways

  • Sector rotation is the act of shifting investment assets from one economic sector to another.
  • The strategy involves using the proceeds from the sale of securities related to a particular investment sector for the purchase of securities in another sector.
  • Sector rotation isn't an easy strategy to manage because there is a lot of risk involved and the costs associated tend to be fairly high.

How Sector Rotation Works

Individuals or portfolio managers may deploy a sector rotation strategy. Sector rotation requires a great deal of liquidity and broad latitude in order to make changes to investment positions within a portfolio. If broad trading flexibility is available, then sector rotation may prove to be a viable way to position investment portfolios to take advantage of market cycles and trends providing for capital appreciation potential in particular areas of the investment universe.

Sector rotation seeks to capitalize on the theory that not all economic sectors perform well at the same time. Put simply, the theory implies that a well-performing sector will continue to outperform only to fall out of favor at some point in the business cycle and be replaced by another sector in the economy. Managers will buy funds when a sector is about to come into favor and sell them when the sector's performance peaks. Portfolio and fund managers use these strategies to rotate investment capital to sectors they feel offer profitable investing opportunities. In-depth research on the economy and data from the National Bureau of Economic Research (NBER) helps to support sector rotation investing. Other types of sector rotation investing may center around seasonal or yearly trends with data supporting advantages to rotating in and out of different profitable categories throughout the year.

Research on market cycles forms the broad basis of investment theory around sector rotation investing. Broad market sector rotation investing seeks to follow market cycles of the economy. These cycles can be characterized in various ways but are usually associated with bullish and bearish outlooks as well as recessions, recoveries, expansions, and contractions.

Sector rotation strategies that follow economic market cycles often seek to identify bullish sector opportunities by expanding markets and mitigating losses through sector rotation to safe havens in recessionary markets. In one sense, sector rotation is a concept that most active portfolio managers keep in mind when they consider all types of investments. However, implementing sector rotation strategies with significant market depth requires comprehensive foresight and access to in-depth market research for success.

Special Considerations

Sector rotation investment funds are not broadly offered for retail investors in the investment universe. Fidelity manages the Sector Rotation Fund, which is now closed to new investors. The fund was launched in December 2009 and invests across multiple asset classes using a fund of funds strategy with ETFs invested across market sectors. Market sector weightings are adjusted based on sector rotation views. As of May 31, 2020, this fund returned 5.29% on a one-year basis and 7.60% since inception.

Several institutional investment managers also offer sector rotation investing strategies. These managers typically use a fund of funds strategy to obtain market exposure. Institutional investment managers offer sector rotation funds based on the sectors of a single economy, or they may also use sector rotation to develop a portfolio of investments across individual countries.

New investors may find ETFs simple to execute through sector rotation, as the majority of sector rotation investment funds tend to be closed to retail investors.

Exchange-traded funds (ETFs) are notably simple to execute through sector rotation, making them a great strategy for new investors. Professionally managed sector rotation funds can be a good investment because they seek to maintain positions in the most profitable areas of the market at all stages of an economy’s economic cycle. More information on these is outlined below.

Disadvantages of Sector Rotation

Sector rotation strategies aren't easy to manage. They come with a great degree of risk because they tend to be fairly volatile. Investors may find their portfolios underperforming the underlying indexes.

Sector rotation can be expensive to implement for a number of reasons. One of the first things to consider is the potential cost associated with extensive market trading, which can negatively affect returns. And moving capital in and out of sectors can be costly due to trading fees and commissions. For that reason, sector rotation is typically a strategy considered for institutional managers or high net worth investors. Sector rotation also requires a very active analysis of investments and economic data, which tends to be much more expensive when compared to a passive fund strategy. It is typically a consideration for professional portfolio managers because of the time constraints and data access involved.