Canadian Securities Course (CSC) Level 2 Practice Exam

What is a key risk associated with sector rotation strategy in equities according to the text?

1. Low trading costs

2. Low volatility

3. Underperformance compared to the benchmark

4. Stable industry rotation

The correct answer is: Underperformance compared to the benchmark

The focus on underperformance compared to the benchmark is crucial when discussing sector rotation strategies in equities. Sector rotation involves shifting investments among various sectors of the economy in response to changing economic conditions, with the aim of capitalizing on the performance of certain sectors at different stages of the economic cycle. However, a key risk is that the chosen sectors may not outperform the overall market benchmark during the period of investment. Investors employing this strategy must accurately predict which sectors will perform best, and incorrect predictions can result in significant underperformance relative to the benchmark. This highlights the inherent risk of timing and sector selection, as sectors can remain stagnant or underperform due to various macroeconomic factors, leading to disappointing returns. In contrast, the other options, such as low trading costs or low volatility, do not encapsulate the primary risks that investors face when implementing a sector rotation approach. A sector may experience stable rotation, but if the selected sector does not align with market movements, the investor could still face underperformance issues. Thus, underperformance compared to the benchmark is a valid concern, particularly in the context of this investment strategy.