Sector Rotation Strategies

ETF sector rotation strategies: what works and what doesn't?

The major reason why I started this website was to determine if ETF sector rotation strategies work. Once I find something that works, I'll post the details of the strategy on this page. In the meantime, here are my initial findings...

Does ETF sector rotation actually work?

In theory, my initial findings confirm that it does. My calculations show that if you had bought $1000 worth of the S&P500 in January 2021 it would have grown to $1409.81 in mid-October 2024. So that's a return of 40.98%.

However, if you had only invested in the best performing of the 11 US market sectors during each month, over the same timescale the $1000 would have grown to an incredible $36,747.42 - a 3674.74% return!

So what's the catch?

The problem is that you would have needed a crystal ball to have determined which sector was going to be the best performer in each particular month. So while such an outsized return is theoretically possible, in practice it is extremely difficult to outperform the S&P500 to this level.

Sector Rotation Strategies

In theory sector rotation does work. So what are some practical strategies that can generate good returns in excess of what the S&P500 index generally delivers?

The first strategy I tried was to determine each month's best performing sector, then rotate into it the following month. This turned the starting $1000 into $1492.39. So this strategy did beat the S&P500 by 5.86% over the timeframe I tried it for. However, this outperformance would almost certainly be significantly reduced once dealing charges and buy/sell spreads are taken into account.

I then tried a similar strategy of determining the worst performing sector each month, then rotating into it the following month. I thought buy low sell high might work. In fact it was a disastrous strategy, turning $1000 into $721.83 - a 27.8% loss.

Despite the failure, this was a very interesting experiment. It appears that buying high and selling higher works much better than buying the losers and hoping for a turnaround. This is an idea popularised by the Dogs of the Dow strategy, but it's possible it doesn't actually work with ETFs, at least on a monthly timeframe.

Avoiding Drawdowns

One reason for implementing a stock rotation strategy is that such strategies can be quite effective at avoiding drawdowns. These are the huge losses that investors can experience during market crashes and bear markets.

The monthly winner rotation strategy I described above was not particularly effective at this. During the time period in question, the worst month for the S&P500 was April 2022 (down 9.11%). The sector rotation strategy's worst monthly drawdown was a whopping -18.15% when it bought into the energy sector in June 2022. Buying the worst monthly performers had a similar result when it bought into Biotech in April 2022 (a -18.31% loss).

To avoid substantial drawdowns it's often better to look at strategies that use technical analysis and charting. The use of moving average crossovers can be particularly effective at avoiding drawdowns from spectacular market crashes, such as what happened in 1987, 2008 and 2020.

To avoid the worst of drawdowns, it might also help to exclude the most volatile sectors. In the time period I looked at Energy and Biotech were by far the most volatile sectors.

Summary

I will continue to work on more strategies for outperforming the S&P500 using ETF rotation. The most promising strategy I've discovered so far is buying the dogs of the ETF universe. From 2022 - 2024 this lead to a spectacular outperformance compared to the S&P500. So be sure to check out my findings on that page.