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Equal Weight Sector Rotation Strategy

11/27/2009

by Hans Wagner

The equal weight sector rotation strategy offers a good alternative for many investors. Many successful investors follow a sector rotation investing strategy. Some of the largest funds and ETFs including the SPDR S&P 500 Index ETF (SPY) base their portfolio allocation on the capitalization weighted S&P 500 index. This sector investing strategy allows you to match the market as defined by the S&P 500. Another sector rotation investing strategy is to equally weight each S&P sector.

Select Sector SPDRs

The Standard & Poor’s Select Sector SPDRs provides a good perspective into the performance of each sector within the market. The Select Sector SPDRs divides the S&P 500 into nine separate sectors. Each Select Sector SPDR is designed to track a particular Select Sector Index. Each sector’s portfolio is comprised of shares of companies included in the S&P 500. Each stock in the S&P 500 is allocated to only one Select Sector Index. The combined companies of the nine Select Sector Indexes represent all of the companies in the S&P 500.

Breaking the S&P 500 into sectors allows you to tailor asset allocations to fit your investment goals. Owning one sector gives you more exposure to certain industries that may be outperforming the market or to hedge other holdings in your portfolio. An individual sector may carry a higher level of risk than the S&P 500 as a whole due to more concentration on one industry. Owing a sector that is beating the market offers you an opportunity to generate returns greater than S&P 500 Index. By picking and weighting these sectors that meet your specific investment goals, you can create a portfolio that meets your perspective of the market and your individual risk assessment.

The table below from Select SPDRs site displays the ten-year returns from sector investing. Notice how each year the performance of each sector varies significantly. In fact, as noted in the chart, “the average difference between the best performing and worst performing sectors has been more than 40% per year. For example, during the height of the dotcom boom, Technology returned 66.69% while Consumer Staples lost 14.49%. In 2000, Consumer Staples delivered 26.04% return and Technology lost 42.04%. If you were on the right side of these sectors during these two years, you did quite well. On the other hand, if you were on the wrong side your portfolio took a significant hit.

Equal Weight Sector Strategy

While there are many sector investing strategies, today we are examining one that equally weights the S&P 500 sectors. If you look at the chart above you will see a “sector” called Equal Weight. The idea is to invest in each sector in equal proportions across the nine sectors. Each sector is weighted 11.1% and the sectors are rebalanced once a quarter. This approach gives you exposure to all the sectors equally. You experience the rallies and the pullbacks of each sector.

According to Standard & Poor’s, the equal weighting sector strategy has lower volatility than the S&P 500. Over the last tens years, volatility as measured by standard deviation was 15.4% for the Equal Sector Strategy vs. 15.8% for the S&P 500. The more volatile sectors such as the financial and technology are more heavily weighted within the S&P 500. On the other hand, the lower volatility sectors such as consumer staples and utilities are underweighted in the S&P 500. By investing equal amounts in each sector, you are skewing your portfolio toward the lower volatility sectors. This results in less volatility than the S&P 500.

Moreover, over the last ten years the S&P equal weight portfolio strategy beat the S&P 500. Had you invested in the S&P 500 ten years ago, your return would have been -0.15%, where as the equally weight portfolio sector strategy delivered 2.83% over the same ten-year period.

As of the end of September 2009, the Materials sector S&P SPDR (XLB) has climbed 38.65 percent, whereas the S&P 500 returned 19.26%. Yet Materials is the smallest sector, comprising only 3.57% by capitalization.

This means if you owned the S&P 500 ETF (SPY) you would have not benefited from the strength in the Materials sector, as it was substantially underweighted. On the other hand had you owned an equal weight of the S&P 500, your portfolio performance would have been higher as the Materials sector would have counted for just as much as Energy sector, one of the largest sectors as measured by capitalization. The Energy sector has underperformed the S&P 500 during this period.

The quarterly reweighting has both pluses and minuses. On the positive side, rebalancing the sectors captures profit from the industry groups that have outperformed the S&P and puts the money into the sectors that have underperformed the market index. You are counting on the rebound of the poor performing sectors while taking profit from the best performing industries.

One of the negative’s of the equal weight strategy, is each time you reallocate your portfolio you must make nine trades to bring each sector back to their 11.1% equal weighting, incurring trading costs. These trades also incur tax consequences, negating some of the advantages of owning an ETF.

For those interested, the Rydex Equal Weighted S&P 500 ETF (RSP) follows S&P's Equal Weight strategy.

Before rushing to switch from the SPY to RSP, investors should be mindful of several risks:

The Bottom Line

A sector investing strategy that equally weights each S&P sector has provided investors with a way to beat the market by taking advantage of the lower volatility that is inherent in the method. It also encourages investors to capture gains by rotating profits from the best performing sectors to the worse performing ones. This can work out to an investor’s advantage, as each year different sectors tend to be the best performers.


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