Sector rotation is a well-respected and widely employed theory of stock market activity. A sector rotation investment strategy entails "rotating" or shifting from sector to sector as the economy moves through the different phases of the business cycle. This typically involves a top-down analysis that includes monetary policy, interest rates, commodity prices, and other economic factors to help assess the current economic environment and determine the current phase of the business cycle we are in. But there are varying methodologies used in gauging and implementing these rotational strategies.
The logic behind such a strategy is that the business cycle will be the predominant determinant of equity sector returns over the intermediate term. While each business cycle may be unique, the phases of the broad economic cycle will tend to have similar characteristics and certain patterns have tended to repeat themselves regularly through time. As the saying goes, while history may not perfectly repeat, it most certainly will rhyme.
The questions that arise out of our recent experience though are: Will sectors continue to provide systematic performance across business cycles? Can unforeseen macroeconomic events or pandemic shocks as we have been experiencing disrupt historical patterns and trends we are relying on? How relevant and flexible are sector rotation strategies in today’s investing environment?
To explore this important investment strategy further, the Institute reached out to Kim D. Arthur, James W. Concidine, and J. Richard Fredericks, the portfolio managers of the Main Sector Rotation ETF (SECT) at Main Management – an independent, San Francisco based advisory firm that was an early pioneer in managing all-ETF portfolios. We wanted to better understand their perspective on the sector rotation investment process and their use of ETFs to implement.
Hortz: In the years that you have pioneered and constructed ETF portfolios, has the evolution of the ETF structure and strategies employed by them changed the way you invest with ETFs?
Arthur: When we started back in 2002, there were fewer than 300 ETFs available worldwide. At the end of 2020, there were over 7,500. The explosion in available ETFs has resulted in lower fees, which is always better for our clients. It has also allowed us to gain exposure to industries and sub-industries which were previously closed off or only available as a part of larger sectors. For example, we can easily invest directly into niche areas such as small cap tech and large cap value which we could not when we first began.
We also make sure to stay current on the evolution of ETF structures. We do invest in active ETFs (ETFs in which managers actively choose the underlying stocks as opposed to index-based ETFs). We feel that there are some areas of the market that warrant active management. For example, the recent rise of thematic ETFs certainly lives in that area. Many companies in these nascent industries live between sectors (like genomics, which combines info tech and healthcare) and as such, we feel that there is a benefit to be gained from a manager making decisions about portfolio construction around companies like those. We do not currently use any defined target ETFs or levered ETFs, as we prefer more plain-vanilla methodologies.
Hortz: Can you explain your dynamic sector rotation strategy and sector weighting process that you employ?
Arthur: We view sector rotation like the old real estate analogy – “location, location, location.” Our goal is finding the correct “locations,” or sectors, that we believe will outperform the broader market. In our allocation, we are overweight sectors that we believe will outperform and underweight sectors we believe will underperform. Much of the process of finding these overweight sectors is driven by fundamental valuation. We look for sectors that we believe are undervalued, however, with a key caveat – they must have a short-term catalyst that will drive their price action.
Hortz: What can you tell us about the historical nature of equity sector rotation? What historically is the time duration for sector rotations to happen, how long do they remain in play, and do they tend to develop whipsaw effects?
Arthur: Equity sector rotation has been around since the sectors were defined. It is driven primarily by macroeconomic cycles which favor different sectors at different times. The duration of these rotations is harder to pinpoint, as cycles vary depending on the economic conditions that are present, but they are more likely to be measured in quarters than in months. They can stay in place for extended periods of time, as evidenced by the multi-year run up to the DotCom Bubble in the Info Tech sector as well as the fairly long-term underperformance of the Financial sector following the Financial Crisis.
They can develop whipsaw effects, but those are more likely to be felt by an investor who bought into an extended sector near the top of the market rather than a disciplined investor who adheres to a longer-term investment plan, like dollar cost averaging. However, outside of bubbles, the whipsaw effects are less pronounced. A sector may go from being the best performing to the worst performing over a couple of quarters without a big event, as it is simply subject to the changing economic cycles.
Hortz: Has the changing nature of the markets over time altered the rotation of stocks from historic patterns? How applicable are historical averages to your decisions?
Arthur: Historical averages and patterns can be helpful, but are not the end-all when making investment decisions. We have seen over the past year that financial markets can behave wildly different that we are used to. Simply investing according to historic patterns does not take in the entire context of the market and may lead to value traps or long periods without reversions to the mean.
Hortz: How dynamic does your dynamic market rotation strategy have to be with the growing volatility and uncertainty of the markets? How do you factor in disruptions like a pandemic and fast changing technology and innovation trends in industries?
Arthur: Over the past 18 years since our founding, we have learned to adapt to volatility, uncertainty, and disruption. Much of our thesis behind sector rotation is the ability to adapt to market conditions and find opportunities even during uncertainty. We believe that by being flexible, we are not bound to only investing in certain sectors during certain parts of the business cycle. Instead, we can use history as a guide, with fundamentals and research as our true drivers.
Hortz: Have you had to change the weighting of your decision factors due to recent market volatility?
Arthur: The weighting of our decision factors fluctuates over time, depending on the market environment. We do not have hard and fast weightings for different factors, rather our investment committee looks at the market environment and applies their experience to the investment process, shifting the weighting among factors in a more informal manner, based on prevailing economic conditions.
In the current environment, fundamental valuations are largely above historical levels across the board. So we are looking at earnings and sales growth forecasts over the coming 1-2 years, which we can use to add context to those elevated valuations and identify areas that are attractive relative to those forecasts.
Hortz: How do you determine the appropriate catalysts or metrics that drive undervalued sectors back to the mean and steer you away from getting stuck as in a “Value Trap”?
Arthur: Our sector rotation strategy uses a 2-step process of identifying areas that are trading at a discount on an absolute or relative basis, and then identifying macro-economic indicators that may serve as a catalyst to drive those prices towards their fair value. A recent example of our process working well was when we tilted towards small cap in our portfolio. We saw that small cap equities were cheap relative to large cap equities, and our catalyst was the fact that small caps have historically outperformed when exiting a recession. This combination of using current context and historical patterns allows us to identify and act on trends without being caught in classic value traps.
Hortz: What sectors are you focused on right now?
Arthur: In the past several months, we have seen a rotation out of growth equities and into value and cyclical equities. Since September 1, 2020, the S&P 500 Value Index is up +3.1%, whereas the S&P 500 Value Index is up +21.8%. Additionally, there has been a rotation in size, from large-cap to small-cap equities. Again, since September 1, 2020, the Russell 2000 Index (small cap stocks) is up +43.6%, whereas the Russell 1000 index (large cap stocks) is up +12.6%.
Over these past several months, we have made a few changes in our Main Sector Rotation ETF (SECT). In broad strokes, we have shifted some growth exposure (Technology sector & Homebuilders) into value (Energy sector) and we have moved some of our large cap exposure down the market cap spectrum (Consumer Staples and Nasdaq into Small Cap Tech and Russell 2000). As such, we were able to benefit from both the rotations into value and small caps, which has driven our ETF’s outperformance over that time frame.
We believe that with the end of the pandemic in sight, investors are rotating out of the pandemic winners (who were primarily growth and large cap stocks) and into value and cyclical stocks who stand to benefit the most from the reopening.
Hortz: Any other observations or recommendations you would like to share about sector rotation strategies as an investment strategy that can inform advisors going forward?
Arthur: We feel that sector rotation strategies absolutely have a place in today’s investing environment. Take a look at what the pandemic has done for sector dispersions. The ability to identify which sectors would benefit from the stay-at-home trade and then which stand to benefit from the reopening process has been a big factor in performance in the past year.
Investing in the wrong sectors at the wrong time can prove very costly. It has been that way in the past and will continue to be that way. More often than not, simply avoiding the worst performers is more valuable than picking the best performers, but in any case, sector rotation strategies have a place in today’s investing environment.