Sector, Factor Strategies Could Help Financial Advisors Focus on Rising Trends

Financial advisors who are looking for an edge can consider several unique approaches for these unprecedented markets.

In the recent webcast, Why Sector and Factor Rotation May Solve Today’s Market Puzzle, Matthew Bartolini, head of SPDR® Americas research at State Street Global Advisors, noted the benefits of sector-specific exchange traded funds that have helped investors gain exposure to specific market segments and target rising trends. Sector funds have had inflows for a record 13 consecutive months, culminating in over $90 billion of inflows during this time period. About 62% of sector funds have had inflows during the record 13 months, higher than the long-term monthly median of 56%.

“Outsized sector flows indicate a significant preference to position portfolios tactically, and beyond just plain broad-based vanilla beta,” Bartolini said.

Looking at the market breakdown, Bartolini noted that cyclicals have had more months with inflows during the rally, but the recent trends have shown a lack of conviction as defensives and cyclicals have traded spots. Only four sectors had inflows in September, reflecting a lack of breadth as the market was a bit choppier — energy was the only one with positive performance. Return dispersion among the 11 GICS sectors is above the historical median level, as leaders and laggards have emerged amid the rally.

After an extended rally and as investors consider where to look for the next opportunities, Bartolini highlighted how cyclical sectors, like materials and energy, screen as trading cheap versus their own historical levels as well as compared to the broader market.

When considering factor plays, Bartolini added that momentum remains strong and valuations stretched for communication services and technology amid continued risk-on positioning. Momentum and earnings sentiment are lackluster for both staples (defensive sector) and materials (cyclical sector), reflecting the disperse market environment.

In this current market environment, Bartolini argued that inflationary pressure and some secular industry trends may persist regardless of short-term market sentiment.

Consequently, “in Q4, we see three industry opportunities that may benefit from inflationary pressures as well as help capture secular trends,” Bartolini said, pointing to real estate, biotechnology, and semiconductor sectors.

To help financial advisors adapt to the shifting conditions, Michael Paciotti, CIO of Integrated Capital Management, highlighted their iCM Tactical Income strategy as a way to create returns in a high-valuation and low-interest rate world. High valuations and historically low interest rates have compressed future return expectations. Consequently, iCM forecasts total returns on U.S. large-cap stocks to be -4.03% annually over the next 10 years, while 10-year Treasuries are expected to return 1.37%.

In a bid to optimize returns for investors, Paciotti highlighted the iCM methodology that focuses on undervalued assets coupled with closed-end funds to enhance income and capital appreciation opportunities.

Paciotti explained that CEFs, which are structured as collective investment companies under the 1940 Act, focus on income, resulting in a universe that is dominated by fixed income funds and those that employ leverage to increase yield. Additionally, market prices have the tendency to trade meaningfully away from a fund’s NAV. This creates unique excess return opportunities for investors.

The TICE Alpha Opportunities Portfolio looks to overcome challenges like high equity market valuations and low interest rates by increasing return potential with attractively valued assets, enhancing yield characteristics with discounted closed-end funds, and adding incremental return to a traditional portfolio via closed-end fund premium/discount alpha.

Additionally, Grant Engelbart, senior portfolio manager at Brinker Capital Investments, outlined their firm’s ETF solutions that focus on factors and sectors. Their methodology begins with a starting point of a low-cost core portfolio that harvests factor premia, which is then applied to major U.S., developed international, and emerging markets.

The portfolio construction process includes factor weightings based on economic regime, relative valuation, and momentum.

“While valuation can vary in its importance across factor structures, we found that longer-term it is a meaningful timing tool,” Engelbart said. “Factor relative valuations are examined with a composite of valuation metrics.”

Furthermore, adding sectors and potentially even industries can open up the opportunity set to enhance returns, Engelbart explained. The portfolio’s sector weights are overweight based on certain criteria like relative valuation and momentum, and the top 2–4 sectors are highlighted and overweight.

Financial advisors who are interested in learning more about sector and factor investment strategies can watch the webcast here on demand.