All investors have one thing in common, and that is their end goal. Everyone wants to make money, and preferrably at a rate that will mitigate the effects of inflation and provide for a comfortable retirement. That means you need to be implementing an investment strategy that outpeforms the S&P 500. Well, in all fairness this may not have always been the case, but over the last decade it certainly stands true. There are many different methodologies that people employ to try to acheive this outperformance. Some turn to analyzing companies’ financial statements and take a fundamental approach, some use quantitative methods, others may look to momentum or relative strength. Each have their pros and cons, and we have talked in past articles about applying these different strategies to the weighting methodologies for various exchange traded products.

Today, we wanted to take a look at how implementing a sector rotation strategy can add value to your portfolio over a benchmark. To do this we took the annual performance of each of the following iShares ETFs from 1994-2010. Because each of these funds track their respective Dow Jones Economic Sector Indexes, we were able to use index data for years prior to 2000 (which was the inception date for each of the ETFs).

• iShares Dow Jones U.S. Consumer Services Sector Index (IYC)
• iShares Dow Jones U.S. Energy Sector (IYE)
• iShares Dow Jones U.S. Financial Sector (IYF)
• iShares Dow Jones U.S. Healthcare (IYH)
• iShares Dow Jones U.S. Industrial Sector (IYJ)
• iShares Dow Jones U.S. Consumer Non-Cyclical (IYK)
• iShares Dow Jones U.S. Basic Materials (IYM)
• iShares Dow Jones U.S. Telecom Sector (IYZ)
• iShares Dow Jones U.S. Tech Sector Index (IYW)
• iShares Dow Jones U.S. Utilities Sector (IDU)

In the table below we have measured several different hypothetical portfolios to demonstrate the importance of sector rotation. Each of these hypothetical portfolios started with $10,000 in 1994. The Buy & Hold Portfolio simply bought and held the S&P 500 Index over the course of the last 17 years. Today, that strategy would have given investors a cumulative return of 169.57%, meaning their $10,000.00 is now worth $26,957. The next portfolio was based on perfect market timing. Simply put, in years when the S&P 500 posted gains, you were long that index. In years when it gave a negative return you were invested in a money market account. That portfolio is now worth over $87,000.

The next two portfolios are the most important in this study, because they truly demonstrate the benefits of being able to accurrately rotate into and out of sectors as trends change in the market. If you bought the best performing iShares Sector ETF each year, your 17-year investing life would have provided a fruitful $1.26 million! On the other side of the coin, buying the worst performing sector each year has left investors with a loss of nearly -90%. Clearly, the proof is in the numbers…sector rotation works. But hindsight is always 20/20. How do you identify these opportunities in real time?

Well, its safe to say that it would have been next to impossible for someone to perfectly select which sector ETF would have been the best performing for 17 consecutive years. So, with that in mind we decided to test two more portfolios. Everyone in the financial industry knows that “past performance is not indicative of future results”, but for the sake of this study, we did in fact base our ETF selection on past performance for these final two portfolios. The first bought the ETF which was the best performing fund in the previous year. The second bought the worst performing fund from the previous year. What we find is that buying the best performing sector fund from the year prior still provided investors with substantial alpha over the S&P 500 benchmark. Conversely, buying the worst performing ETF based on past performance also resulted in underperformance of the market.