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Business News/ Money / Personal Finance/  Can sector rotation be played passively?

Can sector rotation be played passively?

  • Different sectors peak and fall at various stages in an economic cycle. By entering or exiting various sectors at the right time, one can maximize the overall return profile of their portfolio.

At any point in time, the economy will be going through one of these phases: expansion, peak, contraction and trough; and a certain of sectors will always be on winning side of the cycle.

Sector rotation sounds easy to implement, but it can be a complex undertaking. This is because all sectors in an economy do not perform equally well at any given point of time. Different sectors peak and fall at various stages in an economic cycle. By entering or exiting various sectors at the right time, one can maximize the overall return profile of their portfolio.

Sector rotation sounds easy to implement, but it can be a complex undertaking. This is because all sectors in an economy do not perform equally well at any given point of time. Different sectors peak and fall at various stages in an economic cycle. By entering or exiting various sectors at the right time, one can maximize the overall return profile of their portfolio.

Understanding economic cycles

The stock market is intricately intertwined with the economy. At any point in time, the economy will be going through one of these phases: expansion, peak, contraction and trough; and a certain set of sectors will always be on winning side of the cycle. For example, when the economy is in an expansion phase, the financial services and consumer discretionary sectors tend to thrive. When contraction begins, it is consumer staples, healthcare and utilities that can weather this phase well. If a lay investor were to indulge in sector rotation, then he will have to move money away from certain companies or sectors and move on to another set of companies or sectors in anticipation of the performance of the sector(s) in the next stage of the cycle.

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Understanding economic cycles

The stock market is intricately intertwined with the economy. At any point in time, the economy will be going through one of these phases: expansion, peak, contraction and trough; and a certain set of sectors will always be on winning side of the cycle. For example, when the economy is in an expansion phase, the financial services and consumer discretionary sectors tend to thrive. When contraction begins, it is consumer staples, healthcare and utilities that can weather this phase well. If a lay investor were to indulge in sector rotation, then he will have to move money away from certain companies or sectors and move on to another set of companies or sectors in anticipation of the performance of the sector(s) in the next stage of the cycle.

Three years back, the economy had spare capacity and was experiencing weak demand. The post-pandemic recovery was fundamentally driven by the turning of the real estate cycle, with monetary and fiscal policy becoming more supportive of growth. This put cyclical sectors (capital goods, automobiles, cement, insurance and asset management companies) in a good position, and they are still gathering momentum. As the cycle moves forward, it is very likely we may enter a phase when demand exceeds capacity, implying the economic cycle peaking.

Investor dilemma: Identifying the right set of sectors

To play the sector rotation game right, it is imperative for an investor to stay ahead of the curve, for which decisive action is required. Keeping an eye on sectors and the various triggers is time consuming and complex.

There are multiple factors to be considered when comprehending where a sector is with respect to the stage in a cycle: earnings expectations, institutional ownership, sentiment in the IPO market, margins, valuations. For example, over the past three years, PSUs have moved from being one of the cheapest segments in the market to being overvalued.

While economic cycles all follow a similar trajectory, the triggers at any stage could be as varied as monetary policy or a pandemic or a war. Depending on the trigger, some sectors will thrive while others may wither under pressure. One needs to know which ones will be impacted. Another source of uncertainty is the depth and length of a particular stage in the cycle. A miscalculation on this front can do sizeable damage to a portfolio.

Then comes behavioral biases. When a sector is overvalued, there is the affinity to extrapolate the last two years’ growth into the next five years, resulting in suboptimal growth of your portfolio. In 2007, when infrastructure stocks were phenomenally expensive, many investors went overboard and had a suboptimal investment experience over the next decade. Similar was the case with IT in 1999 and pharma in 2015.

Post the macro and sector view comes the stock-picking skills to narrow down on the right company. And then take a call on buying-selling-positioning. Moreover, the tax implications and transaction costs for a retail investor with every buy and sell transaction can take out a significant portion of gains.

Embrace this strategy with a mutual fund

The optimal approach to play sector rotation is via investing in a relevant mutual fund. For such a strategy, a fund of funds (FoF) structure works well. In such a structure, the fund manager, based on his view on the economy, will enter or exit multiple funds as and when the cycle throws up opportunities.

Over the past few years, investors have been increasingly opting for passive offerings. So, if you are an investor looking for passive underlying, then one can consider an FoF offering. Here, the portfolio consists of sectoral or thematic exchange-traded funds to gain exposure to relevant pockets of the market.

Being a FoF, this does not require the investor to open a demat account. If an individual has to invest in each of the ETFs individually, a demat account would be required.

In effect, opting for an offering wherein the fund manager will do the needful on behalf of the investor is the easiest approach to playing sector rotation in a hassle-free manner.

Chintan Haria is principal, investment strategy, ICICI Prudential AMC.

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