The Right Sector Weights An Important Driver of Investment Returns

With earnings slowing down, the U.S. dollar appreciating against foreign currencies and a slipping crude oil market, exchange traded fund investors should consider their sector weights to gain a better foothold for the hurdles ahead.

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Sector allocations are an important driver of investment returns. According to Fidelity data, 22% of a portfolio's performance has been historically fueled by sector factors compared to 4% for market capitalization and 13% for growth or value styles. Consequently, investors who have been too focused on market-cap and asset style weights should consider their sector exposure as an effective way to diminish risk or augment returns.

Currently, given the backdrop of weakening oil prices, some opined that cheaper fuel costs would translate to greater consumer spending and a boost to the economy, which would result in a pro-cyclical bias. However, this has not always been the case.

"When you look back through history, in the nine months that follow significant oil price declines, cyclical sectors on average underperform," Denise Chisholm, a Sector Strategist for Fidelity Investments, said in a note. "What has happened in 2015 is almost right in line with what happened on average since 1970."

Nevertheless, potential investors should note that while history can be a great guide to sector investing, history is no guarantee of future results.

Chisholm also pointed out that we are currently tackling a "profitability problem" where earnings growth is contracting. According to FactSet data, with 63% of S&P 500 companies reported earnings as the end of July for Q2 2016, the blended earnings decline was minus 3.8%, or the first time the index recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.

"Historically, during times of profitability problems, the defensive sectors of consumer staples, health care, and utilities have most often outperformed," Chisolm said. "People tend to buy toothpaste, go to the doctor, and turn the lights on regardless of economic conditions. On the other hand, the technology, industrials, and financials sectors are more cyclical. History suggests they tend to struggle in this type of market environment because their earnings tend to rely on discretionary purchases that can change with economic conditions."

Furthermore, the appreciating U.S. dollar has also been a recent theme, which has contributed to profit deterioration, notably among large multi-nationals with a large international foot print.

"Historically, when the dollar is growing stronger at an accelerating rate, domestically oriented sectors such as consumer discretionary, financials, telecom, consumer staples, and health care have had the highest rate of outperformance among any of the sectors based on rolling one-year relative returns since 1975," Chisolm added.

Consequently, given the earnings slowdown, strong USD and low oil prices, ETF investors should consider overweighting consumer staples, health care, telecom and utilities sectors to diminish portfolio volatility.

For defensive consumer staples exposure, investors can look to a number of sector-specific ETF options, such as the Consumer Staples Select SPDR (NYSE:XLP), Vanguard Consumer Staples ETF (NYSE:VDC) and Fidelity MSCI Consumer Staples Index ETF (NYSE:FSTA).

The Health Care Select Sector SPDR (NYSE:XLV), Vanguard Health Care ETF (NYSE:VHT) and Fidelity MSCI Health Care Index ETF (NYSE:FHLC) provide exposure to the broad health care group, including pharmaceuticals, biotechnology, health care providers, health services and health equipment firms.

Telecom ETFs, such as the Vanguard Telecommunication Services ETF (NYSE:VOX), iShares U.S. Telecommunications ETF (NYSE:IYZ) and Fidelity MSCI Telecommunication Services Index ETF (NYSE:FCOM), include exposure integrated telecom services companies, along with alternative carriers and wireless services.

Lastly, the Utilities Select Sector SPDR (NYSE:XLU), Vanguard Utilities ETF (NYSE:VPU) and Fidelity MSCI Utilities Index ETF (NYSE:FUTY) track electric, multi-utilities and water utilities plants.

The suite of State Street Sector SPDR ETFs have been a mainstay in many investment portfolios. Due to their large size and robust trading activity, the SPDR funds have been go-to options among large institutional traders whom want to execute tight spreads on large block orders. On the other hand, Vanguard and Fidelity options may be more attractive for long-term, buy-and-hold investors as they have lower annual fees and exhibit lower trading activity.

Investors should also consider what brokerage platform they are using as well, since some brokers offer commission-free trades on ETFs, which may further help lower overall fees.

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