ETFs Provide Compelling Implementation Vehicles for Sector Rotation strategies

This article was originally published on ETFTrends.com.

The game hasn’t changed, but better tools may yield better outcomes

Among asset management teams there is a common belief that it’s better to own the worst stock in the best performing sector than the best stock in the worst performing sector. This scenario plays out in almost all cases and underscores the fact that identifying the correct market segment at the right point in the investment cycle is the key driver of investment returns.

Prior to the advent and proliferation of ETFs, Sector Rotation strategies were populated using single stocks. Executing the strategy with individual positions was challenging as you have to get two decisions right –

Correctly identify the right sector, and
Select the right handful of stocks that best replicate the capital weighted performance of that particular GIC sector.

The chart below highlights that even if the correct sector is identified, there is a fairly consistent larger percentage of single stocks that underperform the overall sector by 10% than single stocks that outperform the sector category by 10%. This appears to underscore the fact that the odds are not in the stock picker’s favor.

Given that the challenge involved mastering multiple disciplines, there were few managers that could consistently execute on both fronts, year after year. The onset of ETFs did simplify the process in that pinpointing the right sector was the key exercise. State Street was first to market with the S&P GICS Sectors, all of which currently have sizable trading volumes. iShares has also been instrumental in building out the sector suite, expanding the toolkit beyond US markets.

For those that underestimate the variations in outcomes for each sector, the following chart highlights the array of correlations among sectors. It provides a useful illustration as to how certain sector overweights offer diverse equity exposures and also create opportunities for outperformance due to a wider dispersion of returns.

Managers may seek to overweight particular segments of a given sector that to seek out greater price appreciation than the overall sector. Such industry exposure can potentially amplify a thematic sector exposure with agility and precision. ETFs exist for technology sub-sectors such as software or semiconductors as well as for health care sub-sectors such as biotechnology, a number of which have significant liquidity and offer efficient trading.

ETF Asset Managers are essentially Active Managers of Passive Indexes/ETFs. The goal of each is to generate outperformance over a given benchmark. For Sector Rotation strategies predominantly focused on US Large Cap stocks, the benchmark that most managers aim to outperform is the S&P 500.

There are different approaches to try to outperform the benchmark. Firms using fundamental analysis, such as Main Management, seek to pinpoint undervalued sectors/sub sectors and seek out a catalyst that should propel that sector to revert to its mean. This process involves ranking sectors by valuations relative to their historical average, growth and/or earnings sentiment metrics. Accordingly, sectors with cheaper valuation, higher growth and stronger earnings sentiment are given higher scores. An example of metrics that may be used are illustrated below –

One can express these findings by overweighting favored sector ETFs based on their relative scores and similarly choose not to sectors with less favorable risk/reward metrics. Doing so potentially captures shifts in business cycles as sectors are closely aligned to specific economic variables.

The other well-known approach to sector rotation is tactical management. These are firms that use either technical or proprietary signals to rapidly move in and out of sectors, and potentially move out of the market altogether. Some of these approaches have been highly successful during certain periods (including the 2008-09 recession) but a number have had less favorable outcomes where there have been more consistently positive market returns.

While tactical approaches may have their merits, being tax aware is typically not one of them. While a fundamental manager generally has more judicious turnover, this may generate appealing outcomes on an after fee, after tax basis. The rapid signal changes of tactical models tend to generate a higher proportion of short term gains/losses.

The economy moves in cycles where specific sectors may outperform or underperform during different phases. We believe that ETFs offer a more efficient and one may argue, more effective, means of increasing allocations to sectors expected to outperform and decrease allocations to those that are expected to lag.

Hafeez Esmail is Chief Compliance Officer at Main Management, a participant in the ETF Strategist Channel.

A pioneer in managing all-ETF portfolios, Main Management LLC is committed to delivering liquid, transparent and cost-effective investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency. For more information, visit http://www.mainmgt.com.