Until the advent of the sector-based exchange-traded funds (ETFs), implementing a sector rotation strategy could only be well-executed by large institutional investors. Now with ETFs, individual investors can easily and cheaply implement this strategy.

SEE: Exchange-Traded Funds

What Is a Sector Rotation Strategy?

One way of defining a stocks risk is by breaking it down by: stock-specific risk, market risk and industry risk. Just as most stocks tend to move based on the underlying factors that drive the overall market, stocks in a similar industry will tend to move based on the underlying factors that drive that industry. For example, when oil prices are rising, most stocks in oil-producing companies will follow suit. Similarly, when the subprime mortgage market collapsed, it impacted most financial stocks, as financial companies were owners or originators of those loans.

A sector rotation approach is similar to tactical asset allocation, where investors will allocate their funds to those asset classes which they believe will outperform in the relative short term. In sector rotation, rather than individual asset classes, the investors will allocate funds to different sectors depending on their short-term views. The investor will overweight those sectors that he or she believes will outperform and underweight those he or she believes will underperform.

This sector rotation (or sector allocation strategy) is a top-down strategy. In developing a strategy, an investor identifies key factors within each sector to help predict the future relative performance of the sector, and then the investor will overweight or underweight the sectors based on the current status of those factors. These factors could include:

• Measures of economic activity
• Monetary policy
• Interest rates
• Commodity prices
• Other industry-specific factors.

In the analysis, a long history of data over a number of different economic and market cycles is usually required to identify the key factors and leading indicators that can predict relative performance.

Selecting the Right Family of ETFs

The introduction of sector ETFs has allowed the individual investor to easily implement sector rotation strategies that were not practical before. There are three considerations when selecting the right family of sector ETFs. The first is that the ETF should contain the full spectrum of sectors and stocks that make up an index. Secondly, the index should be broadly based — representative of the overall economy. Lastly, there should be sufficient history on the underlying sectors to be able to carry out the long-term due diligence required to uncover the key factors.

Market-Weighted Sector ETFs

Market-weighted sector ETFs are based on the traditional market capitalization indexes and their underlying sectors. The two largest families of sector ETFs are the Barclays iShares Dow Jones sector ETFs and the State Street Global Advisors sector ETFs. Each covers the full expanse of stocks and sectors that are constituents in their respective indexes.

Barclays iShares Dow Jones sector ETFs use the Dow Jones U.S. index as the underlying index. This index is a market capitalization index designed to represent 95% of the U.S. equity market. The iShares uses the Industrial Classification Benchmark (ICB) system to determine the composition of each sector and sub-sector. ETFs are available for each of the 10 main sector categories.

State Street Select Sector SPDRs use the S&P 500 as the underlying index. It is a market capitalization index representing about 75% of the U.S. equity market. The Select Sector ETFs use the Global Industry Classification Standard (GICS) to determine the composition of each sector. Although there are 10 sectors, there are only nine ETFs, as the information technology and telecommunications sectors are combined to create one technology ETF.

Both the GICS and ICB are biased toward large-cap stocks. Since economic analysis plays a big part in the sector rotation strategy, it is important that the underlying sectors are representative of the broad economy. Using either of the two will provide excellent exposure to the overall U.S. economy and the sectors in it. The iShares ETFs are more comprehensive, but SPDRs have a longer track record.

Equal-Weighted Sector ETFs

Equal weight means that all stocks have a similar weighting in the index, regardless of the size of the company. In a market-weighted index, the large-cap stocks have a greater impact than the small-cap stocks. Therefore, an equal-weighted index will tend to outperform a market-weighted index when small caps are out-performing large caps.

The Rydex S&P 500 Equal Weight sector ETFs are based on the S&P 500 index and the GICS standard. An equal-weighted index is more biased towards small stocks and might not be representative of the overall economy. It is important that the sectors not only represent the entire economy but are also in similar proportion to the index. For example, if the energy sector is 15% of the economy, a 15% weight in the index would demonstrate that it is close to the same representation. An equal-weighted index would overweight small-cap stocks and underweight large-cap stocks. Since large-cap stocks are more representative of the economy, equal-weighted ETFs might not be the best choice when implementing a sector rotation strategy.

Fundamentally Weighted Sector ETFs

A fundamentally weighted index is a relatively new addition to the ETF landscape. Rather than being based on market capitalization or equal weight, the weighting of each stock in the index will be based on the underlying fundamentals. PowerShares has created a series of sector ETFs based on a fundamentally weighted sector index, the FSTE RAFI US 1000 Index. The factors that determine the fundamental value are: sales, cash flow, book value and dividend. Companies that are deemed the largest by those underlying factors will have the largest weights in the index.

There are nine PowerShares FTSE RAFI sector ETFs. The ICB is used to determine the composition of each sector. Information technology and telecommunications have been combined into one sector.

Market weight indexes tend to give greater weightings to overvalued stocks (stocks that have appreciated to high market caps) compared to the underlying fundamentals. This might overstate the importance of those stocks, and their corresponding sector, within the overall economy. Consequently, a fundamentally weighted index might be more closely aligned to the overall economy since the weights of the individual companies are based on size of the company, not just the market cap. Unfortunately, this index does not have the extensive history necessary to determine the underlying factors that drive sector performance.

Sector Rotation Using Only Sector ETF

In developing and implementing a system for sector ETF investment, it is important to select an appropriate benchmark index. Once the index is selected, an investor must understand how the index and the underlying sectors are constructed, as well as how the constituent stocks are chosen. Using the S&P 500 would be a good choice, not only because it has broad large-cap representation of the market, but also because it has a long history.

To demonstrate a simple strategy, lets examine the State Street Select Sector SPDRs ETF, which uses the S&P 500 as the base index. Well assume a $100,000 investment in the strategy. In the table below, we show the sectors, the symbol of the appropriate ETF, the current sector weight, as well as the amount invested in each ETF to implement the strategy.

Example 1: Sector Rotation Strategy Apr. 30, 2008