Passive and Active Investing with Mutual Funds

Mutual fund investment strategies can be boiled down into two distinct groups: passive investing and active investing. Passive investing, which for the purposes of this article includes actively managed funds that are passively held in a portfolio, is also called the buy-and-hold approach—investors simply buy the mutual fund and plan to hold the shares for 10, 20, or even 50 years.

However, while buy-and-hold proponents can make a good case for long-term performance historically and the low complexity of the strategy, these investors have not fared well in recent markets where the 5-year average return for the market is flat, and the average 10-year return is negative. In markets like this, an investor may be able to gain an edge by using mutual funds to employ a sector rotation strategy.

A sector rotation strategy is well-explained by its name—throughout time, you simply rotate into the sectors you believe will outperform the overall market and out of the sectors that will underperform the market. Obviously, the goal is to beat the market by picking good sectors and avoiding bad sectors; but how do you know what is good and what is bad?

Some sector rotation strategists simply time their rotations based on where the economy is in the business cycle to exploit the cyclical nature of some sectors. For example, when the economy is going into a recession (bear market), utilities tend to outperform because they are mature and have very steady cash flows; however, when the economy starts to expand again, financials and consumer discretionary typically outperform since they are seen as leading the way to expansion.

Technology tends to do well in the middle of a bull market while the economy is growing, and energy and precious metals tend to outperform near the peak of the stock market cycle. As the stock market begins to decline and the economic cycle heads towards the peak, health care and consumer staples tend to do well because everyone knows that despite the slowing economy, everyone will still need healthcare and staples such as food.

Now that the economy in our example is declining again, we have come full circle (over a period of a few years), and utilities are once again our choice for investing as the economy falls into recession.

Another strategy, though it is a blend of sector rotation and fundamental value-based investing, is to invest in the sectors that appear to be undervalued. Most sectors go through periods of relative over- and under-valuation, so in this strategy you would buy undervalued sectors and hold them until they becomes fairly valued or over-valued, and then rotate into new sectors.

You can take advantage of a sector rotation strategy by either investing in sectors based on the business cycle or focusing on under- and over-valuation. By employing these two strategies using sector rotation, you will be able to take charge of your portfolio rather than sticking with the old buy-and-hold strategy that has gotten nowhere over the past decade.