Recently there has been increasing commentary from financial media and market participants about the term ‘rotation’ – but what exactly is it and how can managing its effects benefit your investment portfolio?
How rotation works, and when
Rotation is often preceded by ‘sector, style or region’ and it is the act of moving investments from one stock market segment to another. Often, this occurs after a period of strong returns for a segment, which results in excessive inflows. Eventually, when investors perceive the future returns of the popular segment to be limited, they sell those shares and invest in companies in a different sector which is believed to be more promising.
For example, over the past few years, so-called growth stocks such as tech stocks (eg, Tesla, Apple, Amazon) have been very much in the spotlight and favoured by investors for their impressive earnings growth. Conversely, value stocks (believed to be undervalued compared to their fundamental worth) have lagged behind. These are typically in less ebullient sectors such as financial, retail and industrial.
Yet the popularity of sectors usually ebbs and flows in cycles. A sharp barometer of growth stock attractiveness is the tech-heavy Nasdaq Index in the US, which has performed extremely well over the past five years.
Recently, however, the tide began to turn somewhat. The buoyancy which had kept tech stocks afloat has started to spring some leaks, as evidenced by a 15.46% fall in the Nasdaq between 27th December and 27th January.
Growth stocks are typically very sensitive to a credit tightening environment since their future earnings potential is questioned when interest rates are rising. Indeed, since they have been on a heady run over the past three years, it’s not surprising growth companies would lose momentum. Investors seem to be placing more attention on valuation metrics and certainly many growth stocks that have performed the worst recently appear extremely expensive.
Rotations may also occur between asset classes. For several years the financial press has discussed the prospect of ‘The Great Rotation’. This is the idea that given the low prospective return on offer from fixed income securities, there would be a large shift into equities, propelling the stock market higher. Nevertheless, the data shows that this phenomenon has not occurred.
How we manage rotations at Netwealth
There are various reasons that may prompt rotations: changes in monetary policy, geopolitical risk, excessive valuations, politics and even social media trends, to name only a few. All of which are analysed as part of our investment process at Netwealth.
Although our asset allocation framework focuses on a top down, regional approach, we certainly incorporate the sector composition and style characteristics of the exposures into our analysis.
For example, we have recently reduced our exposure to the US S&P 500 index. This exhibits a high weighting to technology stocks, which have come under pressure due to the macro environment. On the other hand, we’ve added exposure to the UK FTSE 100 index, which we feel is undervalued and has been unloved by institutional investors for many years.
That being said, we believe maintaining a diversified portfolio remains key. Rather than aligning all exposures towards one theme, our portfolios exhibit different allocations that will perform differently in different market environments. We think this approach is vital when investing for the long term.
Taking the pulse
To conclude, we keep an eye out for rotations. We aim to understand why and when a trend has run its course or may be about to pivot. As ever, we actively manage the asset allocation within our portfolios, examining the shifting potential of assets (eg, equities, bonds, commodities) and different regions.
We never make rash judgments. Investors can feel reassured we constantly take the pulse of what is happening in markets and in the economy – and only act when necessary to maintain the integrity of their investments.
Please note, the value of your investments can go down as well as up.