Exchange-Traded or ETFs were first developed in 1993 and have become increasingly popular among investors. An ETF is a hybrid investment tool that functions like a stock (is traded on regulated exchanges, its price fluctuates throughout the day, and it can be easily liquidated) but offers the diversification of mutual funds or indexes without the high costs. Many investment professionals are advising clients to add ETFs to their portfolio to further diversify holdings while adding liquidity (ETFs are easier to buy/sell than mutual funds or index funds as the value of the latter is calculated at the end of the trading day and they can only be traded after this has been done, therefore they take longer to liquefy). The investor can either actively manage the assets in the ETF or take a more passive, long-term approach and use a buy-and-hold strategy.
Sector rotation is another possible ETF strategy that involves some active management but also plays into a long-term investment approach. The basic idea behind sector rotation is that the economy operates according to cycles and
some sectors will be up at certain times and down at others. Investors using this approach must identify the boom and bust cycles in the sector they plan to invest in. Then, during the down periods, buy and then turn around and sell when the prices are at their peak right as the boom is ending.
To use a sector ETF rotation strategy, an investor must first decide on the asset allocation for their portfolio. A more diversified investment approach is always safest, so the investor will want to decide what proportion of the portfolio should be devoted to sector rotation and how to invest the remaining portion. Some investors will choose to make ETFs a separate asset class in their portfolios. Other investors may fall in love with ETFs and may want to make them the cornerstone of their portfolio. However, even if you want to keep ETFs as the core of your financial strategy, it is a good idea to split the risks between broad market ETFs and sector ETFs. That way, even if the entire sector goes against your predictions, the losses should be absorbed by your market ETFs.
After determining what percentage of your portfolio to devote to the sector rotation strategy, the next step would be to identify the business cycle that you want to target (it can be a business or calendar cycle – the key is simply to identify it). Once the cycle is identified, the investor then needs to determine which companies benefit from it. Many companies have predictable cycles that are based around the holiday season and will have their peak business during this short window. Retailers certainly fall into this category and an investor may want to shop around for ETFs in this sector around mid-summer (before the back-to-school rush begins). Peak profits will probably come from selling the ETF during the first week of January. Ideally, an investor would have already identified a sector that benefits from the post-holiday boom and is invested in that too. At this point, it would be good to be identifying sectors that would normally benefit from the summer season (travel-related businesses like airlines, hotels, etc.) and be purchasing ETFs now for that period while prices are low. Sector rotating involves always looking ahead to the next cycle while being fully invested in the current one.
During the current cycle, however, the key is to keep rotating in the ETFs relevant to the identified sector. By doing so, an investor should be able to outperform any single sector ETF. This kind of ETF sector rotating strategy involves some research in the beginning but is fairly hands-off once everything is set up. The ETFs will be rotated in and out at predetermined points chosen by the investor.
However, there are other ETF sector rotation strategies for investors to consider. The Stovall Rotation Strategy is a more involved approach that forces the investor to make far more decisions.
The Stovall Rotation Strategy divides the economy into basic sectors: Technology, Basic Industry, Industrials, Cyclicals, Energy, Utilities, Staples, Services, and Finance. The strategy also assumes that each sector is always in one of four stages: early recovery, full recovery, early recession, or full recession. The basic sectors do not all have to be in the same stage at the same time which is where the potential for profits comes in – if investors can predict which sector is about to take off and when the others ones are cooling down – the investor will be able to make money.
The key for investors using the Stovall Rotation Strategy is to always be buying into a sector that is about to take off and selling at the peak to reinvest into the next sector. By remaining fully invested in inexpensive ETFs, an investor is always poised to take advantage of uptrends while being diversified enough across the sector to be reasonably secure against heavy losses. Plus, with so many sectors to choose from, an investor does not have to necessarily have to invest in an area they are uncomfortable with.