Sector Rotation Strategy: How It Works With ETFs and Where It Breaks

A sector rotation strategy moves money between market sectors, such as energy, technology and utilities, based on a rule. The rule tries to hold the sectors likely to lead and step away from the ones likely to lag.

Most versions use one of two signals. Where the economy is in its cycle, or which sectors have been rising fastest.

What is a sector rotation strategy?

The S&P 500 splits into 11 sectors under the GICS system. Real estate became its own sector in 2016. Communication services followed in 2018.

Those sectors don't move together. In 2022 the index lost 18.1 percent. Energy gained 65.7 percent the same year. Communication services lost 39.9 percent.

That spread is the opportunity sector rotation chases. You don't need to pick stocks. You need to pick the right slice of the market, and then leave it at the right time.

Sam Stovall's 1995 book on sector investing made the idea popular with individual investors. The Select Sector SPDR funds arrived in December 1998 and made it cheap to run.

How does a sector rotation strategy work?

1. Define the universe. Usually the 11 GICS sectors, each held through one sector ETF.
2. Pick a signal. Either an economic read or a price read. More on both below.
3. Rank the sectors. Score each one on the signal, highest to lowest.
4. Hold the top of the list. Commonly the top two to four, in equal weights.
5. Rebalance on a schedule. Monthly is most common. Weekly and quarterly versions exist.
6. Decide what happens in a broad decline. Many rules stay fully invested. Some add a cash filter.

Step six gets skipped more than any other. And it matters most.

A pure ranking always owns something. In a market where every sector falls, it owns the ones falling slowest.

What are the two main types of sector rotation?

Business cycle rotation. This model maps sectors to economic phases. Early in a recovery, financials, industrials and consumer discretionary tend to lead. Mid-cycle favors technology. Late cycle favors energy and materials. In a recession, investors crowd into consumer staples, utilities and health care.

The logic is sound. The hard part is knowing which phase you're in while you're in it.

Momentum rotation. This model ignores the economy. It ranks sectors by trailing return, usually over three to twelve months, and buys the leaders. Mebane Faber's 2010 paper on relative strength strategies is the version most people search for. It ranked sectors by trailing momentum and held the top group.

Momentum rotation is a rules-based cousin of factor investing. It bets that recent leaders keep leading for a while.

How do you run a sector rotation strategy with ETFs?

Sector ETFs made this practical. One fund per sector, intraday liquidity, and in-kind creation that keeps most capital gains inside the fund.

A sector ETF rotation strategy holds three or four of those funds at a time. When the ranking changes, it sells the ones that dropped off and buys the new leaders.

Some managers package the whole rule inside a single ETF. That moves the trading and the tax drag inside the wrapper. Read the methodology before the marketing. Two questions decide what you actually own. How often does it rebalance? And can it ever hold cash?

A weekly sector rotation strategy reacts faster. It also trades far more, and every trade pays a spread.

Sector rotation strategy example: 2022 and 2023

Take the simplest momentum rule. At each year end, buy the three sectors with the best calendar-year total return. Hold them in equal weights for twelve months. The figures below are S&P 500 sector index total returns, before costs.

Here's the 2022 basket. At the end of 2021 the leaders were energy at 54.6 percent and real estate at 46.2 percent. Financials came third at 35.0 percent.

• Energy in 2022: up 65.7 percent
• Real estate in 2022: down 26.1 percent
• Financials in 2022: down 10.5 percent
• Basket average: up about 9.7 percent, against an S&P 500 loss of 18.1 percent

A great year for the rule. Now roll it forward.

Here's the 2023 basket. At the end of 2022 the leaders were energy and utilities at 1.6 percent. Consumer staples came third at negative 0.6 percent.

• Energy in 2023: down 1.3 percent
• Utilities in 2023: down 7.1 percent
• Consumer staples in 2023: up 0.5 percent
• Basket average: down about 2.6 percent, against an S&P 500 gain of 26.3 percent

Technology returned 57.8 percent in 2023. The rule didn't own it. The ranking still pointed at 2022's defensive winners when the market turned.

Same rule, back to back. About 28 points ahead one year, about 29 points behind the next. A monthly rule would have caught the turn sooner, but it would also have traded more along the way.

Does sector rotation actually work?

Sometimes. The honest answer depends on the regime.

Momentum rotation does well when leadership is persistent. The 2022 energy run is the textbook case. It does badly at turning points, because the ranking is always looking backward.

Business cycle rotation does well when the cycle is slow and readable. It struggles when the cycle moves faster than the data. The 2020 recession lasted two months, February to April. The NBER didn't confirm the peak until June 2020, and it confirmed the trough in July 2021. By then the recovery trade had already happened.

When does a sector rotation strategy fail?

• Sharp leadership reversals. The 2023 example above. Momentum rules buy last year's story at the moment it ends.
• Broad declines. In 2008 every sector fell. A fully invested rotation just picks which losses to take.
• Narrow markets. When a handful of mega-cap names drive the index, sector labels hide the real exposure. Those names sit across technology, communication services and consumer discretionary.
• Cost and tax drag. Monthly or weekly turnover in a taxable account eats a real share of any edge.
• Crowding. Popular rules trade the same sectors on the same dates. That moves prices against everyone using them.

The second point is the big one for advisors. Sector rotation is a relative bet. It seeks to beat the market, not to step out of it.

That's a different job from risk management. THOR's index rotation approach rotates among three broad equity indexes, not sectors. And it can move to cash when the signals turn off. Our explainer on the THOR SDQ Rotation Index walks through that rule. For the wider family of rules that shift between assets, see tactical asset allocation and trend following ETFs.

Definitions

• Sector rotation. Moving money between market sectors on a rule, to hold expected leaders and avoid expected laggards.
• GICS. The Global Industry Classification Standard. It splits the S&P 500 into 11 sectors.
• Business cycle rotation. Choosing sectors by the phase of the economy: early, mid, late or recession.
• Momentum rotation. Choosing sectors by trailing return, usually over three to twelve months.
• Relative strength. A sector's return compared with the index or with other sectors over the same window.
• Cash filter. A rule that moves some or all of the portfolio to cash when a broad signal turns negative.

Past performance is not indicative of future results. Index figures cited above are public market data and a hypothetical illustration before costs. They do not represent the performance of any THOR fund or strategy, and this material is not investment advice.