By David Sterman

Many investors use exchange-traded funds as part their sector rotation strategies aimed at capturing the winners in the ever-changing economy. Now there are a small (and as of last week, soon-to-be smaller) number of ETFs that do some of the legwork for them by rotating their holdings from sector to sector to keep abreast of broader economic cycles. With the economy moving from a post-recessionary phase into an early growth phase, these funds could capitalize on the sectors and trends most likely to play out in 2012--at least as far as historical trading patterns are concerned.

The ETFs mentioned below take a distinct approach and have a unique set of pros and cons. They also share a major hurdle in that they have short operating histories and have yet to reach prime time status. Daily trading volumes rarely top 10,000 shares, which means wider-than-usual bid and ask spreads. More important, it means they've yet to generate substantial investor interest. In that vein, Guggenheim last week announced plans to close the Guggenheim Sector Rotation ETF. 

Nonetheless, the two surviving funds offer interesting investment strategies.

Horizons Seasonal Rotation ETF (TSE: HAC)

This is the most intriguing option available among the sector rotation funds. Its shares currently are listed only on the Toronto Stock Exchange, but that's not a big drawback because many brokerage accounts now can trade Canadian-listed securities.

Horizon's portfolio managers started this fund with just C$10 million in late 2009, but they have steadily gained a following thanks to strong results and assets are up sevenfold to C$82million. The fund has gained 12% on an annualized basis (compared to 5% for the S&P 500), and 27% overall since inception.

The strategy is pretty straightforward: Fund managers Jon and Don Vialoux consult a large set of investment data compiled by colleague Brooke Thackray. "We have a roadmap of historically demonstrated buy and sell dates during times of the year when markets and sectors have traditionally outperformed because of one or more recurring annual events," says Don Vialoux.

For example, they've recently loaded up on silver stocks while shorting gold stocks as silver tends to outperform gold this time of year. The fund managers consult the annual Thackray investment guide, which has reams of information regarding historical trading patterns. (Author Brooke Thackray is listed as a co-manager of the Horizons Seasonal Rotation fund.) They are also currently sitting on high levels of cash, as the historical data suggest they do at this time of the year.

Because it's a long/short fund, Vialoux notes that it has much less volatility than the broader market. Right now, these portfolio managers think a rising level of exposure to metals and mining stocks, along with industrial stocks, makes sense. "From January 23 to May 5, the industrials tend to outperform," Vialoux says.

Yet advisors and their clients should be aware that this is more like a "1 and 20" hedge fund than a traditional passive ETF. In addition to the 0.75% annual expense fee, the fund managers also take a 20% cut of any profits they secure for investors. Despite that hurdle, the fund has risen by 27% since its launch in late 2009, net of fees.

Rockledge SectorSAM ETF (NYSE Arca: SSAM)

This fund offered by AdvisorShares is the new kid on the block, having launched in January 2012. It may not have an established track record yet, but fund managers at Rockledge Advisors have been practicing the art of sector rotation since 2005. Over the past seven years, their investment sector rotation approach has garnered a cumulative 87% return for clients (compared to an 11% gain for the S&P 500).

Rockledge aims to marry a bottom-up screening approach with a top-down overlay. "We look at stocks on an individual basis but it needs to fit into the context of the economic cycle," says portfolio manager Alex Gurvich.

They generate investment ideas through the use a lot of quantitative screens. "There's no secret black box to it," notes Gurvich, adding that once favorite stocks have been identified in terms of valuation and economic sensitivity, Rockledge then buys the SPDRS that best reflect those stocks.

Rockledge seeks to outperform the benchmark S&P 500 by taking a long/short approach to the portfolio. The fund is currently long materials, technology and energy while short financials, consumer staples, health care and utilities.

Guggenheim Sector Rotation ETF (NYSE Arca: XRO)

Launched in September, 2006, this is (was) the granddaddy of sector rotation funds.  Guggenheim adjusts the fund's portfolio quarterly based on moves by Zacks Investment Services and its proprietary Zacks Sector Rotation Index. The index places heavily-weighted bets in sectors that have been shown to perform well in various phases of the economy cycle. From there, Zacks' bottom-up analysis then seeks to own the top stocks within those sectors.

But the strategy has struggled with a 3% annualized loss since inception. For sure, the fund has come of age during tumultuous times for the financial markets. The Zacks' approach clearly didn't work in 2008 and 2009 as this fund fell in tandem with the broader market and historical sector rotation patterns simply didn't apply. The fund is set to close on March 23. 

 

David Sterman has worked as an investment analyst for nearly two decades. He was a Senior Analyst covering European banks at Smith Barney and was Director of Research for Jesup & Lamont Securities. He also served as Managing Editor at TheStreet.com and Director of Research at Individual Investor magazine. His numerous media appearances over the years include CNBC and Bloomberg TV.