The advent of the sector exchange traded fund (ETF) allows individuals to easily implement sector rotation or sector allocation strategies.
In sector rotation, rather than seeking exposure to individual asset classes, you allocate cash to different sectors depending on their short-term views. Taking a sector approach has benefits, especially when investing in sectors where stock picking is a challenge. By buying ETFs that give you exposure to an entire segment of the market, you can ride the fortunes of an industry while mitigating overall risk.
According to Ken Hawkins for Investopedia, the idea is to overweight sectors that you believe will outperform and underweight those you believe will underperform. [How to Build a Sector ETF Portfolio.]
There are three considerations when selecting 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.
Benjamin Shepherd for MoneyShow reports that the average U.S. business cycle encompasses 60 months of expansion and 10 months of recession. According to the National Bureau of Economic Research, the business cycle involves five phases: three of expansion and two recessions, in which different sectors tend to outperform in each stage. The stages consist of this:
- In the initial expansionary stage, businesses ramp up to fulfill new orders—a boon for technology and transportation stocks.
- During the next phase, basic materials, industrials, and personal and business services benefit from increasing corporate outlays and flush consumers.
- Consumer staples and energy are your best bets in the third expansionary stage.
If you’re taking a sector-focused approach, be sure to consider the need for an entry or exit strategy, as well. As the markets have shown us lately, you can’t rely on past history to predict the future. To find those areas that are moving, watch the 200-day moving average. [How to Follow Trends.]
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Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.