For investors who won’t stomach the risk of altering portfolio allocations, there are other methods to become more defensively positioned, some of which we use in our process as well. Sector rotation is another method that investors can utilize to alter the volatility in their portfolios. When U.S. equity markets are hitting a rough patch, investors have a tendency to rotate more money to defensive sectors such as Staples (XLP), Healthcare (XLV), Utilities (XLU), and Telecom Services (XTL). This makes sense since these sectors usually have lower inherent levels of volatility, higher dividend yields, and less cyclical earning streams. Of course, not every cycle is the same and investors need to be aware of nuances that might make sectors more or less attractive than the typical playbook. For instance, in the current cycle, we are underweighting both Telecom and Healthcare holdings. Telecom companies have arguably become more discretionary in nature, and Health care has enjoyed a big run up during the bull market, boasts a high concentration in volatile and expensive biotech companies, and generates a very high percentage of revenues and profits overseas. That leaves Utilities and Staples to be our preferred domestic defensive plays at this time.
When sector rotating, don’t forget fixed income, as rotating between fixed income sectors can have a major impact on portfolios returns. In the pre-Quantitative Easing world, our cautious stance would call for a large percentage of high quality treasury bonds that typically do well during bouts of volatility. We currently own a healthy percentage of long duration treasuries (TLO/TLT) to defend against the deflationary tendencies in the global backdrop, but we also have been careful to keep cash-like holdings at elevated levels due to the extreme low yield environment and the recent start of a fed hiking cycle. Cash holdings are liquid stability, and for those willing to stomach a very small amount of volatility, ultra-short bond ETFs (ULST) might also make sense. We realize that High Yield Bonds (JNK) are climbing in yield and have arguably discounted more bad news than their equity counterparts, but we are still leery to buy vanilla high yield indices just yet due to their high concentration in the energy patch, and a feeling that the recent widening in spreads may be signaling that things are about to get worse in the global economy.
Today’s investing climate is as challenging as ever, and demands that investors be willing to change with conditions on the ground. Combining asset allocation with ETF sector rotation strategies is our preferred method to navigate through this difficult market environment.
Rick Vollaro is the Chief Investment Officer and a partner at Pinnacle Advisory Group, a participant in the ETF Strategist Channel.