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.