Hortz: How dynamic does your dynamic market rotation strategy have to be with the growing volatility and uncertainty of the markets? How do you factor in disruptions like a pandemic and fast changing technology and innovation trends in industries?
Arthur: Over the past 18 years since our founding, we have learned to adapt to volatility, uncertainty, and disruption. Much of our thesis behind sector rotation is the ability to adapt to market conditions and find opportunities even during uncertainty. We believe that by being flexible, we are not bound to only investing in certain sectors during certain parts of the business cycle. Instead, we can use history as a guide, with fundamentals and research as our true drivers.
Hortz: Have you had to change the weighting of your decision factors due to recent market volatility?
Arthur: The weighting of our decision factors fluctuates over time, depending on the market environment. We do not have hard and fast weightings for different factors, rather our investment committee looks at the market environment and applies their experience to the investment process, shifting the weighting among factors in a more informal manner, based on prevailing economic conditions.
In the current environment, fundamental valuations are largely above historical levels across the board. So we are looking at earnings and sales growth forecasts over the coming 1-2 years, which we can use to add context to those elevated valuations and identify areas that are attractive relative to those forecasts.
Hortz: How do you determine the appropriate catalysts or metrics that drive undervalued sectors back to the mean and steer you away from getting stuck as in a “Value Trap”?
Arthur: Our sector rotation strategy uses a 2-step process of identifying areas that are trading at a discount on an absolute or relative basis, and then identifying macro-economic indicators that may serve as a catalyst to drive those prices towards their fair value. A recent example of our process working well was when we tilted towards small cap in our portfolio. We saw that small cap equities were cheap relative to large cap equities, and our catalyst was the fact that small caps have historically outperformed when exiting a recession. This combination of using current context and historical patterns allows us to identify and act on trends without being caught in classic value traps.
Hortz: What sectors are you focused on right now?
Arthur: In the past several months, we have seen a rotation out of growth equities and into value and cyclical equities. Since September 1, 2020, the S&P 500 Value Index is up +3.1%, whereas the S&P 500 Value Index is up +21.8%. Additionally, there has been a rotation in size, from large-cap to small-cap equities. Again, since September 1, 2020, the Russell 2000 Index (small cap stocks) is up +43.6%, whereas the Russell 1000 index (large cap stocks) is up +12.6%.
Over these past several months, we have made a few changes in our Main Sector Rotation ETF (SECT). In broad strokes, we have shifted some growth exposure (Technology sector & Homebuilders) into value (Energy sector) and we have moved some of our large cap exposure down the market cap spectrum (Consumer Staples and Nasdaq into Small Cap Tech and Russell 2000). As such, we were able to benefit from both the rotations into value and small caps, which has driven our ETF’s outperformance over that time frame.
We believe that with the end of the pandemic in sight, investors are rotating out of the pandemic winners (who were primarily growth and large cap stocks) and into value and cyclical stocks who stand to benefit the most from the reopening.
Hortz: Any other observations or recommendations you would like to share about sector rotation strategies as an investment strategy that can inform advisors going forward?
Arthur: We feel that sector rotation strategies absolutely have a place in today’s investing environment. Take a look at what the pandemic has done for sector dispersions. The ability to identify which sectors would benefit from the stay-at-home trade and then which stand to benefit from the reopening process has been a big factor in performance in the past year.
Investing in the wrong sectors at the wrong time can prove very costly. It has been that way in the past and will continue to be that way. More often than not, simply avoiding the worst performers is more valuable than picking the best performers, but in any case, sector rotation strategies have a place in today’s investing environment.
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