One of the great things about model portfolios is that they offer investors and financial advisors a static allocation to meet their risk profiles and end goals. By having guide rails for allocations, models allow for easy rebalancing. That, in turn, keeps risk profiles in check and helps produce steady returns for the long haul. But, many advisors get hung up because they also believe that what is within those guide rails needs to be static as well.
However, that might not be the best strategy.
Sector rotation for a portion of an equity allocation could do wonders in helping produce better returns. All while supporting a model’s guidance and framework. Even better, ETFs have made sector rotation within a model that much easier.
An Index of Industries
Model portfolios and ETFs have changed the game for many investors in that they can quickly and easily build a portfolio of asset classes to match risk and return profiles. And often, models use broad, index/passive ETFs as their core building blocks. It’s easy to say, “we want 60% of the portfolio in equities”, and then go out and buy an ETF like the iShares Core S&P 500 ETF or Vanguard Russell 3000 Index Fund ETF to meet that goal.
For investors, you instantly get access to a wide range of stocks and diversification. That’s the beauty of diversification and ETFs. You get everything all at once and create a steady average return.
The thing is, not every sector or industry within an index is going to be doing well at the same time. Depending on what is going on with macroeconomic factors, geopolitical worries, or business/consumer trends, the various industries and sectors within the economy/index are going to function differently at different times. Some will zig while others zag. This is particularly true as we move through the business cycle from growth to boom to downturn and eventually recession/contraction.
This is the major tenet of sector rotation.
Here, investors will overweight or underweight the various broad eleven sectors based on the S&P Dow Jones Indices and MSCI Global Industry Classification Standard (GICS) to take advantage of economic trends and stages of the business cycle.
Outperformance Awaits
So, why bother? The simple answer is better returns. For example, the current market malaise and volatility have the broader S&P 500 down about 2% this year. However, looking under the surface, the sectors tell a different story. Only three of the S&P 500’s eleven sectors are lower this year. Nine are beating the index.
This chart from MSCI highlights the different returns for the eleven sectors of the market. As you can see, some sectors have produced losses, while others have produced gains in a given year.
Source: MSCI
Investors who choose a passive index within their model are stuck getting an average return. However, for those willing to focus on the strongest sectors, gains can be had.
An added bonus is that sector rotation and choosing to bet on sectors can provide more diversification while eliminating stock-specific risks. Looking at individual stocks within a sector, many of those stocks managed to underperform their sector. According to SPDR Americas Research, between January 2004 and December 2024, on average 34% of the stocks within a given sector managed to underperform that sector by at least 10%. 1
By choosing a sector rather than individual stocks, investors benefit from portfolio diversification.
Adding Sector Rotation into a Model
The problem is knowing the future. Without the help of a crystal ball, sector rotation seems like a losing strategy. But the reality is, prediction is possible on the sector level. That’s because historical data and the business cycle can provide plenty of clues to making sector rotation work.
The business cycle of expansion, slowdown, recession, and recovery creates different winners and losers. Data and historical returns provide plenty of evidence for this. For example, during periods of expansion, fast-moving sectors like technology and communication services do well, whereas during recessions, consumer staples and utilities are often the top dogs. By tracking the business cycle and the changes in economic conditions, investors can overweight or underweight positions to enhance returns.
For model users and makers, adding a dedicated allocation to sector rotation can provide additional “oomph” to a portfolio and add extra returns to a core equity position. According to State Street, about 6% of an equity position allocated to sector rotation does the job well within a global model portfolio. And of that 6%, allocating about 2% to each of the top three sectors for that stage of a business cycle is how to win.
Financial advisors can accomplish this by using ETFs. There are numerous sector-specific index ETFs from a variety of low-cost issuers that can be used to overweight the winning sectors. As the cycle turns, advisors and investors can sell these ETFs and purchase the next sector-tracking ETFs.
Advisors looking for less of an active and hand-holding approach who still want the ability to add extra alpha through sector rotation have some options. There are a few funds that do the heavy lifting for you. These funds use active or passive indexing to overweight/underweight various sectors and can offer one ticker access to the idea, enhance returns, and be easily added to a model portfolio.
Sector Rotation ETFs
These ETFs use sector rotation as a core foundation of their strategy, either through passive or active management. They are sorted by their YTD total return, which ranges from -0.9% to 0.5%. They have expense ratios between 0.42% and 1.27% and have assets under management between $24M and $2B. They are currently yielding between 0.36% and 5.1%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| SECT | Main Sector Rotation ETF | $2B | 0.5% | 0.36% | 0.78% | ETF | Yes |
| PSTR | PeakShares Sector Rotation ETF | $25M | 0.5% | 5.1% | 1.27% | ETF | Yes |
| INRO | iShares U.S. Industry Rotation Active ETF | $24M | 0.2% | 0.64% | 0.42% | ETF | Yes |
| XLSR | SPDR SSGA U.S. Sector Rotation ETF | $697M | -0.9% | 0.7% | 0.70% | ETF | Yes |
In the end, sector rotation allows investors to enhance the returns of their model portfolios without taking on too much more risk. By focusing on the winning sectors, investors have the potential to produce better long-term results than by simply indexing. The best part is that they can have a home within a model thanks to the use of ETFs. Model makers can easily incorporate sector rotation as a part of their allocations, either by tracking the business cycle or by having someone else do it.
Bottom Line
Sector rotation allows investors to have their cake and eat it too. By following the business cycle and changing small overweight positions within an equity allocation, investors can enhance their returns and reduce single-stock risk. This all can be accomplished via ETFs and model portfolios.
1 State Street SPDRs (April 2025). Sector Investing A Powerful Portfolio Construction Tool
