By John Lunt, President of Lunt Capital Management, Inc.
A few years ago, we took our children snorkeling off the Florida Keys. We told them about the beauty and diversity of sea life that they should expect to see. They were bursting with anticipation as we rode in the boat out to the reef. Their surprise was visible as the boat stopped. The location looked no different than the expanse of ocean we had spent the last several minutes riding through. I could see the look on their faces ask “why here?” To their joy, this question was quickly answered as we dove into the water and discovered a breathtaking world of sea life. The diversity that existed just a few feet below the boat was remarkable. This experience pointed out two things to me—I was glad that some experienced people knew where to take us, and I realized that there is a lot going on below the surface. This stunning underworld was not visible from the boat!
In today’s investment world, it is easy to be frustrated by the investment view from the boat that looks out at the seemingly endless expanse of ocean. We may be moving at full speed up above in the broad asset classes, while completely missing the diversity and activity going on below the surface of the asset class. ETFs have created the ability to dive deeper into each asset class, allowing us to explore segments of asset classes that offer wide ranges of risks and opportunities. This variety of options or dispersion within an asset class is critical when applying any tactical strategy. An investment opportunity set with large spreads across the components invites tactical rotation. In these cases, the broad asset class may be covering or obscuring sub-components with dramatic variations in performance.
At Lunt Capital, we have spent many years exploring and mapping the investment ocean, tirelessly looking for investment reefs with great variety. We have identified four asset class categories or segments with large dispersion across the sub-components of the asset class. These opportunity rich divisions include segmenting by Sector, Geography, Currency, and Factor. In many cases, the sub-components of the asset class are highly correlated. However, this high correlation often masks the scope of the spread between the sub-components. Two sub-components that are up 2% and 20% respectively are highly correlated, but there is a large difference in the scope of performance.
Segmenting an asset class by Sectors is increasing utilized by ETF investors. As an example, the performance of the Technology Sector may be very different from the performance of the Utilities Sector. In 2015, the spread between the U.S. Large Cap Energy Sector and the U.S. Large Cap Consumer Discretionary Sector was more than 30%. Similar sector dispersion exists when exploring Small Cap, Mid Cap, and International Equity markets. This same principle applies when looking at other asset classes, including Commodities and Fixed Income. Large sector dispersion provides ample opportunity to rotate across sectors or to tilt towards (or away from) specific sectors.
Many investors segment portfolios into two buckets: U.S. exposure and “everything else” or international exposure. Even quickly dunking one’s head below the surface reveals that “everything else” is very diverse! In our opinion, the opportunity to segment asset classes by geography or by country offers some of the most compelling opportunities in investing. Country ETFs are fertile grounds for identifying and potentially capturing excess returns and associated risks. The variety of politics, cultures, fiscal policies, and central bank strategies result in a wide range of economic and market outcomes. In today’s ETF market, investors can benefit by being deliberate about what country exposures should be included or excluded within their international allocations.