Imagine it’s 1999 and the dot-com bubble is in full swing. Tech stocks are soaring, but you notice signs of trouble. Instead of following the herd, you shift your investments into the undervalued energy sector. Fast forward to 2010 and your decision has paid off, with the NASDAQ plummeting more than 50% compared to a more than 100% increase in the S&P 500 Energy Sector Index.
However, the 2010 to 2020 decade saw a dramatic reversal, with technology stocks roaring back to life. The NASDAQ skyrocketed by 258%, while the S&P 500 Energy Sector Index saw a modest 3% return. If you took a set-and-forget approach, you would have missed a historic bull market.
The takeaway: Understanding and capitalizing on sector rotation can be a game changer for your investment portfolio, and ETFs offer a versatile way to gain targeted exposure.
Understanding Economic Cycles
Sector rotation strategies capitalize on long-term economic cycles. As the economy expands and contracts, different sectors tend to outperform and underperform depending on their sensitivity to economic growth, inflation and interest rates.
S&P 500 Sector Performance by Year – Source: Novel Investor
In the chart above you can see that the S&P 500 Index posts average performance during most years, but a handful of sectors outperform the benchmark. This suggests that there’s some alpha available to investors who pay attention to macroeconomic trends and adjust their portfolios accordingly.
During periods of strong growth, cyclical sectors like consumer discretionary, financials and industrials thrive. When consumers are confident about their financial prospects, they spend more on nonessential goods and services, helping consumer discretionary companies. At the same time, a strong economy boosts bank lending and raises the demand for industrial products to satisfy the increasing needs.
However, when the economy starts to overheat, the Federal Reserve raises interest rates to contain inflation. Rising interest rates put pressure on cyclical sectors, as borrowing costs increase and consumer spending falls. These dynamics help defensive sectors like healthcare, consumer staples and utilities, which are less sensitive to interest rates – and energy and materials sectors benefit from higher prices.
In today’s economy, the Federal Reserve is seeking to contain high inflation without triggering a recession. Economic growth remains robust, but there’s a risk that the central bank will constrain lending too much or too soon. Meanwhile, stock valuations appear stretched (particularly in tech), meaning investors may be overly optimistic. As a result, a change in the economic cycle may be on the horizon.
Using ETFs to Position Your Portfolio
The SPDR Select Sector ETFs are the most popular option for equity sector rotation strategies. For example, during the bull market over the past 52 weeks, the Consumer Discretionary Select Sector SPDR Fund (XLY) is up nearly 18% compared to just 4.6% for the Consumer Staples Select Sector SPDR Fund (XLP), and the Technology Select Sector SPDR Fund (XLK) is up about 40% versus less than 10% for the Utilities Select Sector SPDR Fund (XLU).
BondBloxx offers the same sector rotation approach for bonds. For example, the BondBloxx USD High Yield Bond Telecom, Media & Technology Sector ETF (XHYT) offers exposure to high-growth, tech-focused companies, while the BondBloxx USD High Yield Bond Consumer Non-Cyclicals Sector ETF (XHYD) provides exposure to more defensive consumer staples companies. But, it’s important to note that bond prices behave differently – what’s bullish for equities may not be bullish for bonds.
If you want a more hands-off approach, several actively managed ETFs offer built-in sector rotation. You get the benefits of diversification across sectors plus a focus on sectors more likely to outperform during the current or upcoming economic cycle.
Sector Rotation Theme-Based ETFs
These ETFs are selected based on YTD total return, which ranges from 0.1% to 9%. The AUM ranges from $5.5M to $1.6B and expenses range from 0.42% to 1%. They are currently yielding between 0% and 6.9%.
| Name | Ticker | Type | Actively Managed? | AUM | YTD Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| SPDR® SSGA US Sector Rotation ETF | XLSR | ETF | Yes | $492M | 9% | 0.7% | 0.7% |
| Main Sector Rotation ETF | SECT | ETF | Yes | $1.6B | 9% | 0.4% | 0.77% |
| BondBloxx USD High Yield Bond Sector Rotation ETF | HYSA | ETF | No | $37.2M | 1% | 6.9% | 1% |
| BlackRock U.S. Industry Rotation ETF | INRO | ETF | Yes | $5.5M | 0.1% | 0% | 0.42% |
- The SPDR SSGA U.S. Sector Rotation ETF (XLSR) is an active ETF that combines quantitative and qualitative analysis to tactically allocate capital among different sectors.
- The BlackRock U.S. Industry Rotation ETF (INRO) is an active ETF that provides low-cost exposure to industries that the portfolio managers believe are well-positioned for outperformance based on forward-looking analysis.
- The Main Sector Rotation ETF (SECT) is an active ETF that seeks to outperform the S&P 500 in rising markets while limiting losses during declines.
- The BondBloxx USD High Yield Sector Rotation ETF (HYSA) is an active ETF that rotates between various BondBloxx sector funds. Currently, it holds a quarter of its assets in the industrial sector and a fifth in the telecom, media and technology sector. Meanwhile, its 7.3% 30-day SEC yield may be a draw for income investors in today’s interest rate environment.
When deciding between these options, investors should carefully consider the fund performance and cost as well as the impact on your portfolio’s diversification.
The Bottom Line
Sector rotation strategies offer a way to generate alpha in your portfolio while maintaining diversification across multiple stocks and industries. With several equity and bond sector ETF options, it’s easier than ever to build custom strategies into your portfolio. Alternately, actively managed sector rotation ETFs can help you benefit from these trends without having to manage exposure over time.