Last Updated on 3 April, 2021 by Samuelsson
Investors are always looking for ways to maximize returns and control the downside risk in their portfolios. While ETFs try to offer diversification and reduce risk, investors are looking for ways to improve the returns from this group asset, which gave rise to ETF trading or rotation. But what exactly is ETF rotation?
ETF rotation is the concept of buying and selling different ETFs at different times to maximize returns. It involves periodically moving money out of ETFs where momentum has slowed into ETFs that show strong momentum or offer better value. ETF rotation strategies are rules-based strategies that investors use to trade ETFs. The strategies try to combine elements of investing and trading to improve returns and lower volatility.
In this post, you will learn the following:
- What ETF rotation is
- How ETF rotation works
- The ETFs that qualify for a rotation strategy
- Common ETF rotation strategies
- How to manage risks when using ETF rotation strategies
What is ETF rotation?
As you know, an ETF (exchange-traded fund) is a portfolio of securities that is traded as a single unit. Unlike mutual funds, ETFs are traded on stock exchanges, just like stocks, and they are not usually actively managed by a professional, so the fees are usually low. ETFs often track a market index, which could be a broad market index or a sector index, but some are made up of uniquely created portfolios.
ETF rotation or ETF trading is the concept of buying and selling different ETFs at different times to maximize returns. It involves periodically moving money out of ETFs where momentum has slowed into ETFs that show strong momentum or offer better value. One of the advantages of ETFs, which make ETF trading possible, is that many of them charge very low fees. Moreover, if there is a lot of liquidity, the bid-offer spread is quite narrow. As a result, ETFs can easily be bought and sold on exchanges without spending too much on transaction charges — the emergence of discount brokers and cheaper operating models makes trading costs quite low.
Before the emergence of ETFs, it would have been too expensive to trade baskets of shares or mutual funds, which are usually actively managed by professionals. The lower ETF trading cost makes it possible to have this new form of investing — ETF trading — which is a combination of passive investing and active trading strategies.
ETF rotation strategies are rules-based strategies that investors use to trade ETFs. The strategies try to combine elements of investing and trading to improve returns and lower volatility by pursuing a diversified portfolio while moving money to only those ETFs that are experiencing good momentum. While many investors are interested in investing and diversifying their portfolio in various global and local sectors, they often don’t know where to start from. With ETF rotation strategies, traders can achieve that goal, and there are many strategies out there, ranging from simple momentum strategies to complex ones like sector rotation and top world country strategies.
While sector rotation tries to move from one sector ETF to another, the top world country strategy aims to rotate money among the broad stock market indexes of top countries in the world, in such a way that money is moved from the poorly performing index ETFs to better-performing ones. There are also other strategies. We will soon discuss them one by one, but first, let’s find out how ETF rotation works and the ETFs that are suitable for the rotation strategy.
How does ETF rotation work?
There are different strategies for ETF rotation, but to explain how the concept works, we will focus more on the sector approach. As you know, there are several sectors of the economy and the market, and they may be grouped as:
- Consumer Staples
- Consumer Discretionary
- Real Estate
Interestingly, there are ETFs that track these sectors, and they perform differently in different market and economic conditions, with some performing better than others in any market and economic situation. Most often, the stage of the economic cycle or the season of the year determines which sectors will perform better in that period, and with that knowledge, an investor can move his money to ETFs in the sector that is doing well at each stage.
One good way to track the various sectors is to use the SPDR sector ETFs. As an example, the chart below shows the one-year performance of ten sector ETFs:
- XLY: consumer discretionary sector ETF
- XLE: energy sector ETF
- XLP: consumer staples sector ETF
- XLF: financial sector ETF
- XLV: health care sector ETF
- XLI: industrial sector ETF
- XLB: material sector ETF
- XLRE: real estate sector ETF
- XLK: technology sector ETF
- XLU: utilities ETF
You can see clearly how outperformance and underperformance tend to persist once they start.
Sector-based ETF analysis may look like the normal fundamental method of investing in individual stocks where an investor seeking to beat the market uses a top-down approach to develop a basic forecast of the economy, and then, followed by an assessment of which industries hold the most promise. But it is not, because in individual stock analysis, after assessing the industries/sectors comes the real work — trying to find the right companies to buy. For this, the investor may spend countless hours reading through research reports and studying financial statements and important financial ratios.
Of course, ETF rotation involves a bit of research to find the sectors that are performing better than the rest. It is easier to identify market sectors that will likely perform well in a particular economic condition than to pinpoint the specific stock that will do well. Hence, ETF trading is an easier way to take advantage of economic cycles by investing in the sectors that are rising and avoiding the ones that are falling.
The investor identifies those sectors that are more likely to benefit from the prevailing economic situation and buys ETFs in that sector. Later, when the economic situation changes and favors different sectors, the investor sells the previous ETFs and buys ETFs in these sectors that are about to benefit from the new economic situation. Interestingly, markets tend to anticipate the sectors that will perform best, often three to six months before that stage of the economic cycle starts. While this requires more homework than just buying and holding stocks or mutual funds, it is not as stressful as researching and trading individual stocks. The main thing is to always buy into a sector that is about to come into favor while selling the sector that has reached its peak.
In essence, ETF rotation is a blend of active management and passive investing. It is active in the sense that investors need to do some due diligence to select the sectors they expect to perform well, but it also has the passive aspect because ETFs, by nature, are diversified and a form of passive investment, which can be held for years.
While low management and trading costs make ETF trading possible, not all ETFs are good for rotation strategies. So, let’s take a look at the ETFs you can use for a rotation strategy.
Which ETFs to use for a rotation strategy?
When using the ETF rotation strategy in your investment plan, the first thing to do is to build a universe of potential ETFs to own. Then, you can create a set of rules you will use to move money from one set of ETFs in that universe to another. Not all ETFs are suitable for rotation systems. Some ETFs are more suitable for the rotation strategy than others. So, it is necessary you know how to pick the most suitable ETFs for trading.
In general, these are the rules to keep when choosing ETFs for a rotation strategy:
- Choose ETFs with lower trading fees
- Go for ETFs with high liquid
- ETFs with large market capitalization are preferable
- If you want to do sector rotation in a particular market — say the U.S. stock market, for example — choose ETFs that track the various sector indexes
- If you want to do country-based rotation, choose ETFs that track the broad market indexes of the different countries of interest
- Avoid smart beta ETFs because they have high trading costs and are already inherently rotated
Basically, choosing ETFs with low costs for rotation strategies allows you to minimize the cost of trading and maximize profits. ETFs with high liquidity and large market capitalization can easily be bought or sold at any time. So, it is good to avoid ETFs with small market caps, low liquidity, or high fees since they can hurt performance.
ETFs that track the broad market index in each country or the MSCI country series are a good way to get exposure to countries and regions and benefit markets that are in the bullish phase while staying away from those in the bearish phase. Also, while smart beta ETFs are fine for long-term investing, their risk management models and high management cost can dampen performance in the short term, so they are not good for rotation strategies.
Furthermore, always avoid gimmicky funds, which invest in sectors that are hot at the time of launch. Here is why: most times, when a specific industry is doing well, ETF issuers will issue funds that invest in that sector, and the time tends to coincide with the peak in share prices for that industry, so over time, the liquidity in the ETF dries up.
Common ETF rotation strategies
The objective of an ETF rotation strategy is to achieve better returns and keep risks low by trading various ETFs rather than buy and hold. There are many ETF rotation strategies out there, but most of them are based on momentum, valuations, and fundamentals data. Some even use multi-factor models that use both fundamental and technical analysis filters to avoid funds that have minimal chances of performing well. For example, a simple technical filter may be to avoid ETFs that are trading below their 200-day moving average since they are technically in a bear trend.
Another filter would be to use the standard deviation of daily returns to avoid the most volatile ETFs in the universe you created earlier. You may also have rules for staying away from the market during a downturn. For example, you can sell off and move into cash when a broad market index or most of the ETFs in your universe enter a bear market. Since ETFs are usually less volatile than individual stocks, it is easier to move into cash without losing much with a portfolio of ETFs than with a portfolio of stocks, as the stocks would have lost much money before you realize what is happening.
While all those are the factor you can use in creating your own rules, let’s look at some of the common ETF rotation strategies out there. They include the following:
- Simple momentum strategy
- US sector rotation strategy
- Universal investment strategy
- Global sector rotation strategy
- The top 4 world country strategy
Simple momentum strategy
In this strategy, the investor aims to concentrate his capital on those ETFs that are experiencing huge momentum by selling the ones with low momentum and buying the ones in good momentum. Here, a basic measure of momentum would be to look at the three-month return.
To reduce risk, a good approach could be to hold the majority of your capital in a broad market index and have a significant portion in a sector with the highest momentum at the moment. For example, rather than holding 100% of your portfolio in SPY, you could hold 60% in SPY, and keep the remaining 40% in the sector with the highest momentum. In fact, you could spread that 40% between two ETFs with the best three-month performance, just to spread the risk out a little more. Then, at the end of every month, you would look at the three-month return for all the sectors ETFs and sell the ones that fall out of the top two and reinvest the money in the sector that replaced it.
While this is a very simplistic approach, it illustrates the idea of using momentum to devise an ETF rotation strategy. In fact, it is the basis of the more sophisticated rotation strategies.
The U.S. market sector rotation strategy
ETF sector rotation is a strategy whereby investors hold an overweight position in sectors that are doing well and underweight positions in weaker sectors. In this case, the focus is on the U.S. stock market sectors, such as healthcare, utilities, technology, financial, real estate, and others.
Concentrating your positions in specific industry sectors offer you a straightforward way to participate in a sector rotation strategy. Sector ETFs that invest in a particular industry can help make sector rotation easier and more cost-effective.
Sector rotation allows investors to stay ahead of economic and business cycles and even take advantage of seasonality changes that happen in the course of the year. Hence, the two main types of this sector rotation strategy are based on:
- Economic/business cycle
- Seasonality changes in a calendar year
Economic cycle based strategy
This strategy assumes that the economy follows a well-defined economic cycle as defined by the National Bureau of Economic Research (NBER). The assumption here is that different industry sectors perform better at various stages of the economic cycle, so investors should buy the ETFs of the next sector that is about to experience a move up. Subsequently, when that sector reaches the peak of its move as defined by the economic cycle, investors should sell that sector’s ETFs.
With this strategy, an investor may be invested in two or more different sectors at the same time as long as they are believed to benefit from the prevailing economic situation at that time. Then, when the economy enters a new stage, the investor rotates from the previous sectors to other sectors that will benefit from the new stage of the economy.
However, the major problem with this strategy is that the economy does not always follow the economic cycle. In fact, economists don’t always agree on the stage of the economy, let alone the market. Unfortunately, misjudging the stage of the economic cycle might lead to huge losses, if the portfolio is concentrated on a few sectors that are assumed to perform well in that stage.
Calendar or seasonality based strategy
The seasonality-based strategy, also known as the calendar strategy, takes advantage of those sectors that tend to do well during a specific season of the year. For example, retailers tend to have more sales during the midsummer period before students go back to school, as well as during the Christmas holiday. So, ETFs that focus on the retailers who benefit from these events should do well during these periods.
Another example is the summer driving season. During this period, people in the northern hemisphere tend to drive their cars more, which increases the demand for gasoline and diesel, creating opportunities for oil refiners. Thus, any ETF that has a significant portion of its holdings in companies that refine oil is likely to benefit during this time of the year.
Universal investment strategy
This strategy is quite simple. In its most basic form, the rotation investment strategy is just switching between the S&P 500 US stock market (SPY) and long duration Treasuries (TLT). Switching between SPY and TLT ETFs is an interesting investment strategy because, most of the time, these two ETFs profit from an inverse correlation — when there is a stock market correction, Treasuries like TLT benefit since they are seen as safe-haven assets.
There are two ways investors try to profit from this inverse correlation. The first one is to always switch to the ETF that had the best performance during the previous 3 months. Historically, this simple switching strategy between TLT and SPY produced a 14.8% return during the last 10 years, with twice the Sharpe (return/risk) ratio of a simple SPY investment. The other method is to invest 50% of your capital in SPY and 50% in TLT and then rebalance each month as the markets move. This method produced an 8.8% return during the last 10 years.
Global sector rotation strategy
Basically, the Global sector rotation strategy (GSRS) uses trend-following and momentum techniques to choose between two portfolios — one is based on different U.S. sectors and industries, while the other is based on global asset classes. Then, from each portfolio, you pick the 3 ETFs with superior relative strength.
The global sector rotation strategy provides a good diversification to your other strategies as the strategy invests in the top two performing global sectors. Since global sector ETFs often display well-defined, long-lasting, uptrends or downtrends, they are a good fit for rotation strategies. Even when the U.S. equity market is moving sideways, other global asset classes will still be performing well.
The top 4 world country strategy
Since ETFs allow investors to take advantage of the investment opportunities in many industry groups throughout the world, the top 4 world country strategy enables one to take advantage of the momentum in different countries using international ETFs, which allow investors to follow investment flows around the world — from developed to developing and emerging market economies.
The top 4 world country strategy is a momentum-driven strategy that invests in the top four single-country ETFs. This strategy adds geographic diversity to your portfolio with significant non-U.S. equity exposure. It consists of four sub-strategies, and here is how it works: each sub-strategy invests in the best country broad market index ETF in a specific geographic area (i.e., Africa, Asia, Latin America, etc).
Then, the strategies are combined to yield four countries ETFs that come from different geographic segments, thereby avoiding overconcentration. In essence, if one region is outperforming all the other areas, this strategy will still diversify among three additional top-performing regions but with the best performing region having more weight.
As with any other investment strategy, before committing your capital, it is important to understand the risks associated with ETF rotation strategies. The rotation strategy aims to concentrate funds in a particular sector or market that is more likely to perform better, but that can pose a problem and bring huge losses if the chosen sector/market ends up doing poorly because you can’t always predict what happens in the market. It is, therefore, important to not create an unwanted concentration in any one sector or market, especially when using a blend of the economic-cycle, seasonality, and country-based strategies.
It makes more sense to invest in several different sectors and markets at the same time but allocate your capital according to your expectations of future performance. This way, you create a more diversified portfolio that helps to reduce the risk of being wrong about any particular sector or market because while an ETF naturally spreads stock selection risk across all companies in the ETF, an ETF that consists of companies in the same sector doesn’t protect from systemic risks.
Another risk management issue, which we have touched on earlier is liquidity. It may be difficult to quickly sell an ETF when you want to. To reduce this risk, try to only trade ETFs that are highly liquid and that have large market capitalization.
To put it all together, investors should understand the investing strategy and portfolio makeup of the ETF before committing capital, and they should focus on ETFs with a huge market.