The Lazy Investor’s Guide To Sector Rotation

An interesting wrinkle in the massive move toward passive investing strategies such as index funds is that a lot of people seem to be ignoring the passive part.

Yes, there are trillions of dollars in exchange-traded funds (ETFs) these days. Rather than buy the index represented by a given fund, many investors are trying their hand at “momentum” investing, also known as “sector rotation.”

The short version of the strategy, which has been studied by academics over many years, is that not all parts of the economy grow at the same speed.

Which is true. For instance, banks might be doing well at one point in an economic cycle, while consumer goods companies do better later. Home builders prosper at one point, while technology firms gain ground in another.

It used to be that investors tried to rotate from one small batch of companies in a sector to another ahead of the crowd. The goal was to get in while prices were low, ride a stock or several stocks upward, then get out.

Buy low, sell high, repeat.

To do this kind of trading consistently well you have to be a master of two very distinct fields of analysis — the fundamentals of corporate earnings reports and the economics of large, complex industries in relation to the economy.

In short, you have to know which companies are likely to do well during an economic upswing in their sector, you have to know when those upswings will begin, and you have to know when they will peak.

The massive availability of corporate earnings data, the Internet and computing power has greatly diminished the edge individual investors once enjoyed in terms of the first problem, corporate earnings. Once hundreds of analysts follow a company, precious little new information enters the public domain without immediate and widespread awareness.

Because of that change many investors have chosen instead to buy indexed ETFs and to focus on the second part of the problem, predicting economic trends.

The result has been a giant increase in turnover. Many funds that were designed for investors to buy and hold are instead traded nonstop. They are very cheap to buy and sell, in some cases at zero cost.

Low cost should be a reason that investor performance improves, not a reason to trade more, but the opposite has occurred. ETF turnover is now several times over the total turnover of all U.S. stocks.

Does all this trading achieve anything, even if it’s done very cheaply? Not according to data from J.P. Morgan. The average investor over the 20 years ending in 2016 realized an annualized return of 2.3%, barely exceeding inflation of 2.1%.

The S&P 500 during that period returned 7.7%. A portfolio of 60% stocks and 40% bonds returned 6.9%. Just owning a 100% bond portfolio garnered 5.8%.

Let the chips fall

So, is there any place for momentum trading? Sure, if you fully accept the fact that some investors will do well at it and some will do horribly and that the difference equals the stock market index return.

If you are certain for whatever reason your strategy will put your portfolio in the winner’s circle, trade away. If not, you should expect to get the wrong end of the stick and see returns closer to the average investor in the J.P. Morgan report.

There is another course. A proven way to “rotate” is to instead own a portfolio of multiple asset classes using low-cost ETFs and to rebalance. By letting the market dictate prices, you can consistently take gains and reinvest in those asses that are out of favor.

Rather than try to predict what’s next, you let the chips fall where they may and execute trades after the fact. Rebalancing is the only free lunch in investing and the surest way to allow compounding create investment wealth over time.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.