What is Sector Rotation - Uses, Pros & Limitations

Like any other country, the Indian economy moves in somewhat predictable cycles with stages like expansion, peak, contraction and trough. The current economic cycle influences company performance, lending and investment rates, currency exchange rates, employment and other important factors. Investors also cycle through different sectors to adjust to different market conditions and get the most optimal returns. 

Sector rotation is the process followed by market-savvy investors to optimise their investment in changing markets. Read this blog to learn about sector rotation in the Indian stock market and how to use this strategy to your benefit. 

What is Sector Rotation in Trading? 

Sector rotation is a top-down investment approach where investors move money from one sector to another based on the market situation. It is a tactical asset allocation strategy where investors sell off their holdings in one sector and reinvest the proceeds in another, based on the current stage of the economic cycle. 

As the economy of any country moves in well-known cycles, industries and companies in a sector experience bullish and bearish cycles based on the current economic stage. This has given rise to the sector rotation strategy, where investors buy stocks in undervalued sectors and sell them when the sector is overvalued. 

How Does Sector Rotation Work in Stock Market? 

In India, there are two broad categories of companies: cyclical and non-cyclical. Cyclical companies are susceptible to changes in the business cycle, while non-cyclical companies are mostly unaffected by it. 

Cyclical stocks include industries like banks, automobiles and luxury goods, and their returns depend on the current business cycle. Non-cyclical stocks include healthcare and utilities, which feature stable demand and returns. 

The concept behind sector rotation is to use the predictable nature of cyclical stocks to enter and exit investments. Investors buy cyclical stocks right before the economic cycle begins to favour them and shift the investment to non-cyclical sectors when cyclical stocks start underperforming. Another reason for sector rotation is that returns from stocks in the same sector are similar, allowing for sector-wise allocations. 

Let’s understand this with an example. 

Say you invested 50% of your portfolio in financial services, 20% in household consumables and 30% in the automobile sector. Now, you learn about upcoming interest rate changes causing losses to the financial and automobile industries. 

To optimise your returns, you can sell half of your investments in both cyclical sectors and invest in household consumables, a non-cyclical sector. Now, you have 25% investment in financial services, 15% in automobiles and 60% in household consumables.

Top Strategies for Sectoral Rotation 

Here are some of the top strategies for sectoral rotation:

• Balance Between Cyclical and Defensive: It's a good idea to invest across cyclical sectors in bullish markets, as these sectors tend to perform well. Non-cyclical or defensive sectors perform better in bearish cycles. Sectors such as consumer staples, utilities and healthcare also tend to perform well during periods of high inflation and low GDP growth.
• Invest in Dividend Yield Stocks: High dividend-yield stocks are good investments during inflationary periods and economic downturns. These stocks also tend to outperform other sectors in rising interest rate environments. Another reason to invest in these stocks is that they provide a steady income besides capital gains. 
• Diversify Across Market Cap: Besides sectoral diversification, you should also rebalance your large-cap and small-cap investments. You should increase your large-cap investments and lower your small-cap investments when anticipating a falling market and vice versa. 
• Frequently Rebalancing: You should be aware that sector rotation is an active investment strategy. Even if you invest via sectoral funds and ETFs, you need to monitor the market and buy/sell accordingly. 

Benefits of Sector Rotation 

Here are the top reasons why you may want to consider sector rotation:

• Long-term Preparations: Since the economy moves in cycles that are well-known, you can anticipate the next cycle months in advance and move your money.
• Diversifies Your Portfolio: Sector rotation prevents your portfolio from being concentrated in a single sector. Instead, you put your money across different sectors and markets, lowering your portfolio risk.
• Unlocks Higher Potential Returns: By shifting your investments to sectors that are about to perform well, you can increase your profit potential. Investing ahead of the cycle also lets you invest at low prices and sell at high prices. 
• Professional Fund Management: For investors who do not have the knowledge for direct investment, there are many professionally managed options for sector-wise investment, including sectoral mutual funds and ETFs (exchange-traded funds). 

Limitations of Sector Rotation

Here are some of the limitations of sector rotation you should be aware of:

• Concentration Risk: If you shift your investments to a few sectors expected to perform well, you will create a concentrated portfolio. This can result in major losses if your expected results do not come true. 
• Need for Precise Timings: Sector rotation is not the most popular investment strategy as it requires in-depth knowledge. Furthermore, they must perfectly time the entry and exit points, which requires constant monitoring. 
• Performance Biases: Investors often end up chasing sectors and themes that have performed well recently. This can result in losses as investors enter at the peak of the economic cycle, and returns keep falling afterwards. 

Final Word

Sector rotation is an investment strategy that uses well-established theories of market cycles in economics to its advantage. By studying past historical trends and staying updated, you can stay ahead of the market and invest in sectors about to take off. Even if you do not want to invest in specific sectors, you should understand sector rotation to be prepared for major economic changes.

Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.