Sector Rotation

Q: Rachel, a portfolio manager, reviews economic data showing GDP growth accelerating to 4.5%, unemployment declining to 3.8%, and consumer confidence reaching multi-year highs. Corporate earnings are beating expectations across most sectors. A client asks about adjusting their portfolio to capitalize on these trends. Which sector allocation change would be most appropriate based on this business cycle phase?

**B is correct.** The economic indicators (strong GDP growth, low unemployment, high consumer confidence, strong earnings) signal a robust expansion phase. During expansion, cyclical sectors like technology and consumer discretionary typically outperform because they benefit most from economic growth, increased consumer spending, and rising business activity. A is incorrect because utilities and consumer staples are defensive sectors that outperform during contraction, not expansion. They provide stable returns but lag during strong growth periods. C is incorrect because moving entirely to defensive sectors during expansion would sacrifice growth opportunities and underperform the market. D is incorrect because reducing equity exposure to cash during expansion means missing substantial market gains. This is the wrong phase to become defensive.

Q: Which of the following sectors are typically classified as defensive sectors that tend to outperform during economic contraction?

**B is correct.** Utilities, consumer staples, and healthcare are defensive sectors that provide essential goods and services with stable demand regardless of economic conditions. During contraction, these sectors tend to outperform because consumers continue purchasing necessities (food, electricity, medication) even when discretionary spending declines. A is incorrect because technology, consumer discretionary, and financials are cyclical sectors that perform well during expansion but typically underperform during contraction as spending on non-essential goods decreases. C is incorrect because construction, manufacturing, and industrial materials are highly cyclical sectors that suffer during economic downturns when business investment and consumer demand decline. D is partially incorrect because while telecommunications can be somewhat defensive, real estate and energy are cyclical and tied to economic growth.

Q: An investment adviser implements a sector rotation strategy by shifting 20% of a client portfolio ($80,000 out of $400,000 total) from technology sector funds into utility sector funds. Three months later, technology sector returns +12% while utilities return +2%. What is the opportunity cost of this sector rotation decision?

**B is correct.** Calculate the opportunity cost: - Technology gain forgone: $80,000 × 12% = $9,600 - Utility gain achieved: $80,000 × 2% = $1,600 - Opportunity cost: $9,600 - $1,600 = $8,000 The adviser missed $8,000 in potential gains by rotating out of technology at the wrong time. This demonstrates the risk of active sector rotation strategies. A ($1,600) is incorrect because this is only the gain achieved from utilities, not the opportunity cost. C ($9,600) incorrectly represents only the technology gain forgone without subtracting the utility gain received. D ($10,000) appears to round up the technology gain incorrectly.

Q: All of the following statements about sector rotation strategies are accurate **EXCEPT**

**C is correct (the EXCEPT answer).** This statement is FALSE. Sector rotation is NOT a passive strategy. it is an active management approach that requires tactical decisions to shift allocations among sectors based on economic cycle analysis. Passive strategies maintain consistent allocations regardless of economic conditions. A is accurate: sector rotation is definitively an active strategy that attempts to time sector performance based on business cycle phases (expansion, peak, contraction, trough). B is accurate: cyclical sectors benefit from economic growth and consumer spending increases during expansion, making them outperform defensive sectors during these periods. D is accurate: sector rotation requires frequent rebalancing and trading, which generates higher transaction costs, advisory fees, and potentially short-term capital gains tax liabilities compared to passive buy-and-hold strategies.

Q: An economist forecasts that the current economic expansion is nearing its peak, with GDP growth slowing from 5% to 2%, unemployment at historic lows but wage pressures increasing, and the Federal Reserve signaling potential rate hikes to control inflation. Which of the following sector rotation adjustments would be appropriate in anticipation of a transition from peak to contraction? 1. Reduce allocation to consumer discretionary sector 2. Increase allocation to technology growth stocks 3. Increase allocation to utilities and consumer staples 4. Reduce allocation to financial services sector

**C is correct.** Statements 1, 3, and 4 are appropriate sector rotation adjustments. Statement 1 is TRUE: Consumer discretionary stocks (retail, restaurants, leisure) are cyclical and typically decline during contraction as consumers reduce non-essential spending. Reducing exposure before the downturn preserves capital. Statement 2 is FALSE: Technology growth stocks are cyclical and rate-sensitive. Increasing allocation to tech stocks as the economy approaches contraction and the Fed raises rates is inappropriate. tech stocks typically underperform during contraction and in rising rate environments. Statement 3 is TRUE: Utilities and consumer staples are defensive sectors that outperform during contraction because they provide essential services with stable demand. Rotating into these sectors before economic weakness protects portfolio value. Statement 4 is TRUE: Financial services (banks, brokers, insurance) are cyclical and sensitive to economic activity. As the economy transitions from peak to contraction, loan demand decreases, credit quality deteriorates, and trading volumes decline, making this sector vulnerable to underperformance.

Investment Vehicles High Relevance

An active investment strategy that shifts portfolio allocations among different economic sectors based on business cycle phases. Certain sectors (technology, consumer discretionary) typically outperform during expansion while others (utilities, consumer staples, healthcare) perform better during contraction.

Example

As economic indicators signal recession, a portfolio manager reduces technology and consumer discretionary holdings (cyclical sectors) and increases allocation to utilities and consumer staples (defensive sectors) to preserve capital during the downturn.

Common Confusion

Students often confuse sector rotation with market timing or think it is a passive strategy. Sector rotation is active management based on economic cycles, not short-term price movements. Additionally, students may misidentify which sectors are cyclical versus defensive.

How This Is Tested

Identifying which sectors outperform during expansion versus contraction phases
Recognizing sector rotation as an active management strategy with associated costs
Understanding the relationship between business cycle phases and sector performance
Distinguishing between cyclical sectors (discretionary, technology) and defensive sectors (utilities, staples)
Evaluating the limitations and risks of sector rotation strategies

Regulatory Limits

Description	Limit	Notes
Active management disclosure requirement	Must disclose higher fees, costs, and tax implications	Investment advisers must inform clients that sector rotation is active management with associated transaction costs and potential tax consequences

Example Exam Questions

Test your understanding with these practice questions. Select an answer to see the explanation.

Question 1

Rachel, a portfolio manager, reviews economic data showing GDP growth accelerating to 4.5%, unemployment declining to 3.8%, and consumer confidence reaching multi-year highs. Corporate earnings are beating expectations across most sectors. A client asks about adjusting their portfolio to capitalize on these trends. Which sector allocation change would be most appropriate based on this business cycle phase?

Question 2

Which of the following sectors are typically classified as defensive sectors that tend to outperform during economic contraction?

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Question 3

An investment adviser implements a sector rotation strategy by shifting 20% of a client portfolio ($80,000 out of $400,000 total) from technology sector funds into utility sector funds. Three months later, technology sector returns +12% while utilities return +2%. What is the opportunity cost of this sector rotation decision?

Question 4

All of the following statements about sector rotation strategies are accurate EXCEPT

Question 5

An economist forecasts that the current economic expansion is nearing its peak, with GDP growth slowing from 5% to 2%, unemployment at historic lows but wage pressures increasing, and the Federal Reserve signaling potential rate hikes to control inflation. Which of the following sector rotation adjustments would be appropriate in anticipation of a transition from peak to contraction?

1. Reduce allocation to consumer discretionary sector
2. Increase allocation to technology growth stocks
3. Increase allocation to utilities and consumer staples
4. Reduce allocation to financial services sector

💡 Memory Aid

Think of sector rotation like changing clothes with the seasons: In summer (expansion) you wear shorts and t-shirts (cyclical sectors = tech, discretionary). In winter (contraction) you bundle up in a warm coat (defensive sectors = utilities, staples, healthcare). You rotate your wardrobe based on the economic weather, not random timing.