Note: This article appears on the ETFtrends.com Strategist Channel
By Jan Erik Wärneryd
In a previous article [An Introduction to Investing in Sector ETFs] I discussed the importance of considering the long-term relative growth of various industries when evaluating sector ETFs. In this article I will share a bit about how we at Hillswick incorporate shorter-term macro-economic factors into our strategy.
Many equity portfolio managers like to tell investors they focus solely on stock-picking; finding the best companies according to whatever criteria they focus on while disregarding the broader economy. The idea is that this narrow focus at the company level is where the added value lies, since forecasting the economy is difficult and not even economists seem to be very good at it!
At Hillswick, we see this as an opportunity. Since it is likely the market in specific stocks is fairly efficient given all the focus and effort devoted to analyzing them, we seek to add value by incorporating macro-economic views in our sector rotation strategy. Using sector ETFs takes the focus away from individual stocks and allows us to look at the “big picture” and to incorporate both long-term factors such as share of GDP and shorter-term ones such as FED policy and currency moves.
My own background is in Global Macro trading and portfolio management, where strategies are adopted based on expected changes in economic conditions in whatever markets and countries represent opportunities. This perspective comes in handy even when working within the more limited opportunity set of the S&P 500 Index since most large corporations are exposed to global factors.
Among the most obvious global Macro factors to look at are global growth prospects, currency moves, political events and changes in commodity prices. These are all exogenous, or externally driven, factors that have the power to impact the U.S. economy and in particular corporations with international operations and/or significant trade exposure.
Currency moves, for example, impact prices received and paid for exports and imports (transaction exposure) and the relative competitiveness of one country versus another. They also impact the value of a company’s assets abroad (translation exposure). If the U.S. Dollar increases in value versus other currencies, U.S. based exporters receive fewer Dollars when exchanging their foreign currency income whereas importers to the U.S. benefit from lower prices. Since U.S. corporations have significant holdings of foreign assets, there is a negative balance sheet effect when translating the value of these holdings back to U.S. Dollars if the Dollar strengthens.
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When looking at how the S&P 500 Index is impacted by currency exposure a few sectors stand out; Industrials and Health Care (Drug Companies) for example, have high foreign exposure whereas Utilities and Real Estate do not.
On a side note, the Energy sector may be the sector that has the highest negative correlation with the USD, but that effect may be through the price of oil rather than through the USD directly; the price of oil tends to fall when the USD is strong and vice versa.
Interest rates are another factor that can have a significant impact on relative sector performance. For example, Utilities are frequently bought as a bond alternative, where the focus is on the dividend yield. Higher interest rates will impact the Utilities sector negatively the same way that bonds decline in value when rates go up.
Where to start
As a general rule, the starting point for incorporating macroeconomic views should be a view of how the Global economy may look over the next few quarters. As always, when you link sector performance to the economic outlook you run the risk of “being late to the party” – the market may have already priced in the scenario you see unfolding.
A better approach to using macroeconomic views to inform your investment strategy, and one we use at Hillswick, is to build an independent economic outlook and then contrast it with what the market is already expecting. By studying imbedded pricing we can determine the risk premium between “our” outlook and the implied market forecast and aim to determine what is already “priced in” to the market. If the premium is large enough, we will then position ourselves to take advantage. This approach avoids getting trapped in consensus positions with little upside potential.