Investing in Sector ETFs: What is Sector Rotation?

How sector rotation works

Sector rotation is an active, top-down strategy – but what does this mean?

An active strategy means it involves frequent buying and selling of assets based on the investor's judgments rather than a passive strategy, which typically follows a fixed index.

A top-down strategy focuses on macroeconomic factors to make investment decisions, starting with the big picture of the economy and then drilling down to sectors and industries.

The strategy is based on the premise that there are observable, repeatable, and consistent phases in the macroeconomic cycle. Each of the distinct 11 stock market sectors responds differently to these phases, either historically favorably or unfavorably.

For instance, defensive sectors with inelastic demand, like healthcare, utilities, and consumer staples, tend to outperform during economic downturns or recessions. This is because their products and services remain in demand regardless of the economic climate.

Conversely, cyclical sectors like consumer discretionary and technology tend to perform well during economic expansions when consumer spending and business investments are on the rise.

There is no universal way to implement sector rotation. Some funds use quantitative models driven by momentum, sentiment, or valuation signals, whereas others rely on qualitative analysis. Most strategies combine both approaches to some extent. The key is to anticipate and stay ahead of economic changes, making sector rotation a tactical strategy.

Given the frequent adjustments and high turnover involved in sector rotation, using ETFs with low bid-ask spreads and expense ratios can help keep costs low compared to assembling your own basket of sector-specific stocks.

Are there sector rotation ETFs?

If you have your own sector rotation methodology, you can easily mix and match different SPDR Select Sector ETFs to implement it. However, if you trust the professionals and want a hands-off approach, there's an option for that too—the SPDR SSGA US Sector Rotation ETF

For a 0.7% expense ratio, this ETF aims to outperform the S&P 500 Index by tactically allocating among the 11 Select Sector ETFs. The fund uses both quantitative and qualitative analysis, along with a risk budget, to make its allocations.

XLSR has a high turnover rate, rebalancing every month but adjusting as needed depending on market conditions. As of July 2, 2024, the ETF is poised to capitalize on continued economic expansion and bullish market momentum. It has the highest weights in technology at 43%, followed by industrials at 19% and financials at 15% - all three of which are cyclical sectors.

Unfortunately, since its inception in April 2019 to May 31, 2024, XLSR has underperformed the S&P 500 Index, with a 12.1% annualized return compared to 14.44% for the index. This underperformance highlights the risks of actively managed funds and the impact of high expense ratio;

What's next?

As part of our mission to bring you comprehensive ETF educational content, we'll be continuing this sector investing primer with a series covering all 11 SPDR Select Sector ETFs. This series aims to provide you with introductory knowledge on each sector, helping you understand their unique characteristics and investment potential. Stay tuned as these will be released one by one over the coming weeks!

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.