ETF with industry rotation strategy

Many investors are interested in investing in and diversifying their portfolios in various global and local sectors, but are often not sure where to start. Industry rotation is a strategy used by investors. They increase their positions in strong industries and decrease their positions in weaker industries. Exchange-traded funds (ETFs) that focus on specific industries provide investors with a way to directly participate in industry rotation. ETFs also allow investors to take advantage of investment opportunities in many industry groups around the world. (To understand the basics of sector rotation, see Sector rotation: essentials. For more information about ETFs, please refer to our tutorial: Exchange Traded Fund Investment.)

In this article, we will show you three different industry rotation strategies and determine why ETFs help smooth the path of each style.

Key points

  • Industry rotation enables investors to stay ahead of the economic and business cycles.
  • Investing in industry ETFs in specific industries can help make industry rotation easier and more cost-effective.
  • International ETFs can also allow investors to track the flow of investment from developed countries to developing countries to emerging market economies around the world.

Why do investors choose industry rotation?

As the economy moves forward, different economic sectors often perform better than others. The performance of these departments may be a factor of the business cycle stage, calendar, or geographic location.

Investors seeking to beat the market may spend countless hours reading articles and research reports. Using a top-down approach, they can make basic forecasts of the economy and then assess which industries are the most promising. Then the real work began-trying to find the right company to acquire.

A simpler option is to use ETFs that focus on specific industries. Industry rotation takes advantage of the economic cycle to invest in rising industries and avoid falling industries. (Keep reading about the ups and downs of cyclical stock investment.)

Sector rotation is a combination of active management and long-term investment: active means that investors need to do some homework to choose the sectors they expect to perform well; long-term, because you can hold certain industries for many years.

The market tends to predict the best performing industries, usually three to six months before the start of the business cycle. This requires more homework than just buying and holding stocks or mutual funds, but less than the homework needed to trade individual stocks. The key is to always buy the industries that are about to be favored, while selling the industries that have reached the peak.

Investors may consider three industry rotation strategies for their investment portfolios. The most famous strategy is to follow a normal business cycle. The second strategy follows the calendar, while the third strategy focuses on geographic issues.

Business cycle strategy

Standard & Poor’s Sam Stovall describes an industry rotation strategy that assumes that the economy follows a clear economic cycle defined by the National Bureau of Economic Research (NBER). His theory asserts that different industry sectors perform better at different stages of the economic cycle. The Standard & Poor’s sector is matched to each stage of the business cycle. Each sector follows a cycle determined by the economic stage. Investors should buy the next industry that is about to rise. When an industry reaches the peak of volatility defined by the economic cycle, investors should sell the ETF industry. Using this strategy, investors can invest in several different sectors at the same time while rotating from one sector to another—all of which are guided by the phases of the economic cycle.

The main problem with this strategy is that the economy does not usually operate exactly in accordance with the defined economic cycle. Even economists cannot always agree on economic trends. It should be noted that misjudgment of the stage of the business cycle may lead to losses, not gains.

Calendar strategy

Calendar strategies use departments that tend to perform well at specific times of the year. The midsummer period before students return to school usually creates additional sales opportunities for retailers. In addition, the Christmas holiday usually provides retailers with additional sales and travel-related opportunities. ETFs that focus on retailers that benefit from these events should perform well during these periods.

There are many examples of consumer events for a specific cycle, but an easy-to-categorize example is the summer driving season. People in the northern hemisphere tend to drive more in summer. This has increased the demand for gasoline and diesel, creating opportunities for refiners. Any ETF that holds a large number of shares in a refinery company may benefit. However, as the season ends, the profits of ETFs in related industries will also decline.

Geographic strategy

The third sectoral rotation view that investors can adopt is to choose ETFs that can take advantage of the potential benefits of one or more global economies. Perhaps a country or region is benefiting from the demand for its products. Or maybe the economic growth of a country is faster than the rest of the world. ETFs may provide investors with an opportunity to take advantage of this trend without having to buy individual stocks.

Manage risk

As with any investment, it is very important to understand the industry rotation strategy and the risks of the corresponding ETF before investing money. By investing in multiple different industries at the same time, weighting according to your expectations of future performance, you can create a more diversified investment portfolio that helps reduce the risk of errors in any particular investment. The ETF strategy will naturally spread the risk of stock selection to all companies in the ETF. However, investors should be careful that they will not cause unnecessary concentration in any one sector, especially when using a mix of economic cycles, calendars, and geographic strategies.

Since there are so many ETFs available to investors, it is very important to understand ETF investment strategies and portfolio composition before investing capital. In addition, low-volume ETFs pose additional risks because they may be difficult to sell quickly without potential stock bids.

Bottom line

By investing in diversified ETFs, investors can take advantage of the upward trend in certain industries while reducing the risk of losses due to high-risk stocks. In addition, by selling part of your holdings in industries that are at the peak of the cycle and reinvesting in industries that are expected to perform well in the coming months, you will follow a strict investment strategy. (Also take a look: A disciplined strategy is the key to high returns.)

The industry rotation strategy using ETFs provides investors with the best way to improve the performance of their investment portfolios and increase diversification. Before investing money, be sure to evaluate the risks of each ETF and strategy.

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