Sector rotation is an investment strategy that involves shifting capital between different sectors of the economy in response to changing economic cycles or market conditions.
Understanding sector rotation
The global economy moves through distinct phases of expansion, peak, contraction, and trough. Different industries perform better during specific phases of this cycle. Investors using this strategy move their money from a sector expected to underperform into one expected to grow based on the current economic environment.
During an economic recovery, industrial and basic materials sectors often see increased demand as manufacturing ramps up internationally. When an economy enters a recession, defensive sectors like utilities or consumer staples generally retain their value. Consumers continue to buy basic necessities and pay for electricity regardless of broader economic conditions.
You can apply sector rotation using exchange-traded funds or mutual funds that track specific industries. This provides broad exposure to the sector without the need to select individual stocks. The strategy requires active management and regular monitoring of macroeconomic indicators like global interest rates and manufacturing output.
Example
As Elephants building a global equity portfolio, you observe that several international central banks are raising interest rates to combat inflation. This signals a potential economic contraction. To implement sector rotation, you sell your holdings in consumer discretionary funds, which track companies selling luxury goods. You then move that capital into the healthcare and utilities sectors. People continue to buy medicine and pay for water during an economic downturn, meaning these sectors generally maintain their value. When macroeconomic indicators suggest the global economy is entering a recovery phase, you shift your funds again. You rotate out of utilities and purchase shares in technology and industrial funds to capture the upcoming growth.