By Marc Odo, Swan Global Investments
In a recent blog post, we made the case for equally weighting the various SPDR sector ETFs to gain our market exposure in the flagship U.S. Large Cap Defined Risk Strategy. Investors frequently have follow-up questions on the equal-weight strategy, which we will address in this “Frequently Asked Questions” format.
Q: Do you equal weight in the other strategies?
A: No. The equal weight is only used in U.S. Large Cap strategies. There is simply not enough coverage or liquidity to implement a sector based approach using sector-specific small cap ETFs. PowerShares released a series of small cap sector funds in 2010, but these were shut down due to lack of interest. Today the availability of small cap sector funds can be described as patchy, at best.
In the international space, the same lack of complete coverage/liquidity on a country-basis precludes us from doing something similar in equally weighting country ETFs. Instead we simply use the big, broad ETFs covering Russell 2000, MSCI EAFE, and MSCI EM for our other DRS strategies.
Q: What are the sectors/ETFs used in this approach?
We use the State Street Select Sector SPDRs ETFs in our sector-based approach. Those ETFs are:
- Consumer Discretionary (XLY)
- Consumer Staples (XLP)
- Energy (XLE)
- Financials (XLF)
- Heath Care (XLV)
- Industrials (XLI)
- Materials (XLB)
- Real Estate (XLRE)
- Technology (XLK)
- Utilities (XLU)
Q: Under the equal-weighted allocation, which sectors are under- or over-weighted relative to the S&P 500?
The precise numbers are always in a state of flux. However, generally speaking, the equal weighted approach tends to overweight Utilities, Energy, and Materials relative to the S&P 500. The underweights are to Technology, Financials, and Health Care.
Q: What impact does the equal-weighted sector approach have on the equity portfolio characteristics?
Essentially this approach gives the portfolio more of a value-tilt. There is also a bias away from the mega-cap names that dominate the S&P 500. If one believes in the “value premium” and the “size premium” that was described in the Fama-French factor models, this approach emphasizes those factors.
In years when growth does better, like 2015 or 2017, the equal-weight strategy tends to lag. In years when value does better, like 2016, the equal weight has outperformed the S&P 500. Also, the equal-weight approach tends to do better in down markets. This is the primary reason for implementing the equal-weight approach.
Looking at the historical track record of an equal-weight sector strategy versus the cap-weighted S&P 500, the overall portfolio tends to have lower risk. Metrics like beta, standard deviation, and drawdowns have been lower than the S&P 500.
Q: Why isn’t Telecoms represented in this sector line-up?
It is true that the S&P GICS structure (i.e., Global Industry Classification Standard) has a separate sector dedicated to Telecoms. However, when State Street was putting together their line-up of sector ETFs in 1999 they encountered a problem. There simply were not enough large cap Telecom companies available to form a viable ETF. There were only about two dozen Telecom companies, not enough to warrant a stand-alone ETF. So back at the inception of the sector ETFs in 1999, State Street rolled those companies into the Technology ETF.
Q: How did you deal with the XLRE carve out?
Prior to autumn 2016, Real Estate was a portion of the overall Financials sector. Under this structure, all nine sectors were truly equally weighted, each having a target allocation of 11.11% of the equity position. The decision by S&P GICS to treat Real Estate as a separate sector, and State Street’s subsequent decision to create XLRE ETF, necessitated some changes to an equal-weight sector approach.