As the economy moves through the stages of the business cycle, most investors expect certain sectors or industries to outperform other segments of the market. Sector-based assets or funds enable investors the opportunity to take advantage of the business cycle, using what is called a “sector rotation strategy.”
The economy moves in cycles and specific sectors and industries within the economy will be likely to perform better in particular stages of the economic cycle.
Sectors enable investors to potentially take advantage of changes in the business cycle. Sector rotation is a strategy that involves investing in sectors that are expected to perform well at a particular time, based on where the economy is in the business cycle. The expectation is that the investor will “rotate” in and out of sectors as time progresses and the economy moves through the different phases of the business cycle.
Essentially, an investor would increase their allocation to industries that are expected to benefit from the stage of the business cycle, and under allocate to industries that are expected to underperform. This goal of this strategy is to construct a portfolio that will produce investment returns superior to that of the overall market.
Sector rotation is similar to tactical asset allocation. Instead of investing in a particular asset class—such as stocks, bonds, or commodities—in order to take advantage of current market conditions, the investor is constructing their portfolio selected economic sectors or industries. Depending on their views, an investor might overweight sectors that they believe will outperform and underweight those that are expected to underperform the market.
Why choose a sector rotation strategy?
One underlying premise of sector rotation strategies is that the investment returns of stocks and other securities from companies in the same industry tend to move in similar patterns. This is because the price of stocks in the same industry usually move based on similar fundamental and economic factors that drive a particular industry. For example, new developments and uses of technologies fueled growth in the technology industry, and most stocks in this sector trended higher. Alternatively, most stocks in the financial sector moved sharply lower during the collapse of the subprime mortgage market and the subsequent credit crisis. This downtrend in banks and other similar businesses during the financial crisis demonstrated how stocks in the same industry can be affected by overarching industry factors, and thus, stocks in the same sector exhibit similar performance to changes in the business cycle.
To implement a sector rotation strategy, many investors choose to take a top down approach. This can involve an analysis of the overall market—including monetary policy, interest rates, commodity and input prices, and other economic factors. This can help investors form an expectation for the broad economic environment.
Key economic factors for each sector or industry are used to create an estimate of future performance for each sector. The next step might be to identify sectors or industries that may be well-positioned for the current and future stages of the business cycle. Depending on the phase of the business cycle—early stage, mid-growth, late-stage, and recession—certain sectors may be expected to outperform, given the investor’s broad economic assessment. An assessment of the economic environment and stage of the business cycle provides investors with one basis for determining which sectors to allocate their capital to.
While each economic atmosphere is unique, certain sectors tend to perform well—given the stage of the business cycle (see chart below).
Best performing sectors in each stage of the business cycle
|Three stages of expansion||Two stages of recession|
|Stage I||Stage II||Stage III||Stage IV||Stage V|
Measuring & Control Equip.
Steel Works Etc
Non-Metallic & Metal Mining
Ships & Railroad Equip.
Beer & Liquor
Candy & Soda
Petroleum & Natural Gas
Gas & Electrical Utilities
Automobiles & Trucks
Printing & Publishing
Restaurants, Hotels, Motels
Rubber & Plastic Products
Source: Standard & Poor's Guide to Sector Investing 1995
The market outlook is one of several factors used by investors to determine sector allocations. Risk management through diversification should be an important objective for investors, and so it is worth assessing the return correlations between the sectors and to the overall market.
Of course, diversification does not guarantee against a loss. For instance, an investor may not be able to suitably diversify their portfolio simply by evenly dividing capital among all of the different sectors. Instead, the diversification benefits of a sector rotation strategy might be improved by shifting capital allocations in relation to changes in the investment and economic environment.
Since return correlations between sectors can differ in relation to changes in the business cycle, investors should consider this when over allocating to sectors or industries. Consequently, investors may be able to optimize the expected risk-adjusted return of their portfolios.
Investors can use a sector-based strategy to construct their portfolio in a variety of ways, and there are a number of vehicles that can help accomplish this objective.
In the past, in order to gain exposure to an entire sector or industry, an investor might have had to buy the stock of many companies. Unfortunately, the amount of capital required to accomplish this would be quite significant, and it would be with great difficulty as well.
Thankfully, investors can now take advantage of sector-based mutual funds, exchange-traded funds (ETFs), and other securities to gain exposure to entire segments of the market. These funds are constructed to represent an economic sector. They allow investors to gain the desired sector allocations without having to invest large amounts of capital.
These vehicles allow investors to more easily execute a sector rotation strategy and tactically change their equity portfolios in order to increase exposures to sectors they feel have the best return potential. By allocating capital to specific sectors, investors also run the risk that a portfolio will be positioned sub optimally. It is important for investors to understand that taking an active view on what is likely to happen in the market may result in lower investment returns or higher return volatility, if their views are incorrect.
Sector rotation strategies can help investors align their investments with their market outlook. With an understanding of how certain sectors react to the business cycle, investors may be able to optimally position their portfolio.