SMI's Sector Rotation Strategy
Continues to Impress — Oct 2005

Two years ago we introduced a strategy that more experienced investors could use in conjunction with our core Upgrading approach. It involves the use of "sector" funds. As we explained last month (see Sector Funds: Investing in the Economy "By the Slice"), sector funds are special purpose stock funds that invest in very narrow slices of the economy. Most commonly, they include such specialized investing themes as technology, health services, precious metals, natural resources, communications, financial services, and real estate.

Rather than gaining broad diversification, investors in sector funds are buying into a concentrated portfolio that restricts its reach to a particular sector of the economy. As the economy goes through the ups and downs of the business cycle, conditions favor certain types of businesses at certain times. In other words, all the sectors don't rise and fall together. When the sector in which a fund specializes is doing well, the results can be sensational. (For example, natural resource funds are up 32% this year through August while stocks overall have been flat.) By the same token, when tough times hit that sector, the fund suffers along with it because the manager lacks the flexibility to switch into something else. (Stocks were up 11% last year but gold funds fell 8%.) Thus, sector funds live a sort of "rags or riches" existence, which explains the fact that the average sector fund is about 50% more volatile than the market in general.

So, what's needed is a methodology that allows you to invest in a sector fund during its period of popularity as well as alerts you when the ride is over and it's time to move to another sector that's doing well. In other words, an approach similar to the one we use in our Fund Upgrading portfolios. Fortunately, our crackerjack research team came up with just the decision-making formula. When applied to historical data going back to 1990, it showed average results of 32.5% per year, and would have multiplied your capital by over 50 times. Pretty eye-popping numbers. But that was all theoretical. How has it done in real time?

Quite well. The technology trade that was in progress when the strategy was announced was closed out with a gain of 82.0% over a holding period of 19 months. It was followed by an energy-oriented fund last September. As energy stocks continued to prosper this year, our recommended sector fund has been profitable for us in 9 of the 12 months we've held it. Our paper profits as of 8/31 were 81.6%.

If you're interested in learning more about incorporating this sector fund strategy into your investment portfolio, see our Advanced Strategies page. 

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