Tactical Applications Of Sector ETFs

Year-to-date, flows to sector exchange traded funds have been mixed. Five of the nine sector SPDRs issued by State Street Global Advisors (SSgA) have lost assets, but that does not tell the entire story.

Predictably, rate-sensitive sector funds, including the Consumer Staples Select Sector SPDR (NYSE:XLP) and the Utilities Select Sector SPDR (NYSE:XLU), have lost assets. However, XLP is up 6.4 percent this year and flirting with all-time highs. XLU, though down on the year, has improved in recent weeks against the backdrop of investors expecting interest rates to remain low for the foreseeable future.

Although a frequently-heard battle cry of ETF supporters is that ETFs trump stock picking, data suggest that with sector ETFs, that is much more than a clarion call. The Energy Select Sector SPDR (NYSE:XLE) is a prime example of that.

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Take energy stocks as an example. In the past year, the decline in the price of oil has roiled energy markets and sent the price of the S&P Energy Select Sector fund down some 35%. Had an investor attempted to 'play the energy sector' through a single stock, returns could have performed much worse than the broad sector. In fact, the chart 'Energy Sector Price Returns' showsthat in this case, the return on the sector was better than the average and median stock return, illustrating how a more broadly diversified sector can lower the potential for stock-specific risk and provide the desired exposure to macro-based themes in an efficient manner, said SSgA Vice President Dave Mazza in a recent blog post.

Mazza pointed out that as XLE slumped nearly 35 percent from late September 2014 through late September 2015, the median loss by the ETF's holdings was nearly 42 percent. As just one example, XLE has outperformed Chevron Corp. (NYSE:CVX), the ETF's second-largest holding, by 200 basis points over the past year.

Another consideration with sector ETFs is correlations. As ETFs have gained popularity and adoption of the asset class by professional investors has surged, frequent have been allegations of ETFs leading to increase correlations through various corners of financial markets. However, data suggest not all sector intimately tied to the whims of the broader market.

Over the last 17 years, the S&P 500 Indexs average correlation to growth and value is 0.98 and 0.97, respectively. Meanwhile, average sector correlations to the broad market are much more diverse, ranging from 0.60 for Utilities to 0.92 for Industrials, adds Mazza. A lower average correlation means returns are more differentiated from each other which may positively impact asset selection strategies, such as rotating between sectors to manage risk and potentially improve diversification.