Note: This article is part of the ETF Trends Strategist Channel
By Jan Erik Wärneryd
Sector ETFs give investors the opportunity to position themselves in whole sectors of the economy rather than having to pick stocks. This puts the focus more on Macro, or big picture, drivers of returns rather than company-specific factors.
There are many different approaches to the timing of sector plays; many investors start out by forecasting where we are in the business cycle and then look at how sectors have performed historically in the scenario they expect will play out.
This style of investing requires the strategist to make an accurate assessment of where the economy is going over the next quarter or two while also relying on historic return patterns to repeat themselves.
As more investors “learn” what these patterns are and how sectors should perform over the cycle, there is a risk that these opportunities are arbitraged away. There is also the risk that the forecast is simply wrong and that the economy behaves differently than forecast or that unforeseen events derail the outlook.
Other strategists look at price momentum and choose sectors based on relative performance by buying the best performing ones while under- or zero-weighting the laggards. This requires frequent rebalancing as momentum, while being a factor that has been shown to produce excess return, has a short shelf life and therefore calls for active management.[related_stories]
At Hillswick, we have chosen a different approach in managing the Hillswick S&P 500 Sector Selection strategy; one that combines a value-driven factor approach with a Macro overlay.
We seek to position our portfolio to take advantage of long term positive return factors such as value and low volatility, while also avoiding the pitfalls of a pure model-driven approach. By adding a discretionary element we have been able to steer clear of value traps such as Financials in 2008 and Energy in the last few years.
Our strategy blends a value-driven approach where we try to determine which sectors will give us a tailwind over the next 1-3 year period based on valuation relative to growth prospects and other factors that we believe will lead to outperformance.
Let’s look at one of the variables we consider in building our Sector ETF portfolio.
Growth in Relative Share of GDP
As long-term investors, we pay attention to which sectors are likely to gain share of GDP over time versus those that see their share decline. As mentioned in our previous article, Is It a Right Time to Invest in Energy ETF’s?, the Energy sector is a perfect example of a sector that loses share of GDP over time. In 1950, energy expenditures were about 16% of GDP according to the U.S. Energy Information Administration (EIA). In 2015, energy is down to less than 6% of GDP.
To get an idea of which sectors have gained or lost share of GDP over time, we need to find the right data. The Bureau of Economic Analysis publishes time series data that breaks down the U.S economy by industry and sub-industry going back over many decades. We could choose any starting point but why not look at the economy since 1995, just over 20 years ago and arguably the year the Internet broke into the mainstream.
The data can be presented in many different ways and for this instance we have chosen Chained Quantity Indices, and have then normalized the data to a common starting point of 100 in 1995.
Just to give some examples; Computers and Electronic products grew by 200% between 1995 and the end of 2014, whereas manufacturing only grew by 27%.
Broadcasting and Telecom, perhaps surprisingly, grew by 160% in the same period.
Another surprise: Finance and Insurance grew by 90% versus an overall economic growth of 52%, even including the financial crisis of 2008-2009.
The chart below shows growth trajectories relative to the starting point in 1995
A Practical Example
For a practical example of how to apply the data to picking sector positioning, let’s look at our reasoning around the Consumer Discretionary and Staples sectors. Using Retail as a proxy for consumers, we find it interesting to note how Broadcasting and Telecom has seen tremendous growth while Retail has performed broadly in line with the economy as a whole. Judging by the market’s valuation of these sectors one would think Consumer Discretionary and Consumer Staples are the growth sectors, since they have the highest P/E ratio in the S&P 500 Index.
Telecom, on the other hand, is seen as a boring Utility-like sector with little or no secular growth and therefore trades at the lowest P/E ratio in the index. Could it be because most of the focus is on stock-picking in the consumer sectors? Maybe investors believe they can pick better than average stocks in these slow-growing sectors and outperform that way?
Since we don’t have the option of picking stocks, we are more interested in the outlook for the entire sector and our overweight in the Telecom sector is a reflection of that. We currently have a small underweight in Consumer Staples and a significant underweight in Consumer Discretionary based partly on the above data but also other factors that drive our sector positioning.
As mentioned above, the relative growth characteristics of sectors is one input to our ultimate sector weighting but there are many other factors to consider as well.