Sector rotation refers to selling shares or funds that are invested in one sector and use the money to re-invest into another sector. This strategy helps investors to capitalise on a change in economic conditions and the anticipated performance of those sectors in specific stages of the economic cycle will lead to higher returns.

This sector rotation strategy is a type of an active investment strategy in contrast to so-called passive investing strategies where investors buy the stocks or funds and hold onto it for years.

So, sector rotation works by ‘rotating’ in and out of various sectors to take advantage of changes in the phase of the above business cycle from expansion to contraction. Because some sectors are inherently more sensitive to economic changes than that of others, rotating money in or out of stocks or funds that track those sectors could result in higher returns.

Also Read: 8 key investment strategies for maximising returns

What are the types of business cycle?

There are four clearly distinct phases of a typical business cycle, namely early cycle phase, mid cycle phase, late cycle phase, and recession phase. Generally, a sharp recovery from recession, marked by an inflection from negative to positive growth in economic activity then an accelerating growth rate. Credit conditions stop tightening amid easy monetary policy, creating a healthy environment for rapid profit margin expansion and profit growth.

Business inventories are low, while sales growth improves significantly are the characteristics of an early cycle phase. Mid cycle phase, typically the longest phase of the business cycle, is characterised by a positive but more moderate rate of growth than that experienced during the early cycle phase. Economic activity gathers momentum, credit growth becomes strong, and profitability is healthy against an accommodative, though increasingly neutral, monetary policy backdrop. Inventories and sales grow, reaching equilibrium relative to each other.

Late cycle phase is of an overheated economy poised to slip into recession and hindered by above trend rates of inflation. Economic growth rates slow to stall speed against a backdrop of restrictive monetary policy, tightening credit availability, and deteriorating corporate profit margins. Inventories tend to build unexpectedly as sales growth declines. Finally, the recession phase features a contraction in economic activity. Corporate profits decline and credit is scarce for all economic factors. Monetary policy becomes more accommodative and inventories gradually fall despite low sales levels, setting up for the next recovery.

What are the risk factors?

Sector rotation strategies help the investors align their portfolio with the market outlook and the different phases of the business cycle. However, by adopting a sector rotation strategy, one runs the risk that their portfolio may experience increased volatility compared with a buy-and-hold strategy that tracks the broader stock market and thus sometimes, the portfolio may underperform the broader market indexes. Further, sector rotation strategies increase transaction costs, if your broking house charges for every transaction of buying or selling and it may also create tax consequences depending on if one is booking profit.

To conclude, sector rotation is a popular way to pursue an active investing strategy by rotating in and out of sectors based on what is happening in the economy. While this strategy is a good active investment strategy, remember that it does not ensure a profit or guarantee against a loss.

(By P Saravanan, professor of finance & accounting at IIM Tiruchirappalli. Views are personal)