With the SPDR S&P 500 (SPY) up 15.8 percent year-to-date, now is the time to drill down on what sectors have been driving the broader market's bullish ways and what industry groups have been laggards. It is possible that some old laggards will become new leaders while it is also possible that this year's outperformers will continue to deliver alpha next year.
There is something else to note about sector ETFs. With bond, dividend and emerging markets ETFs among the leaders in terms of 2012 inflows, many sector funds are suddenly starved for attention.
Take those ETFs that are not heavily exposed to major bank stocks or Apple (AAPL) out of the equation, and it is fair to say that, while not forgotten, some focus has shifted away from sector ETFs in recent months. That does not mean investors will face a dearth of opportunities at the sector level in 2013. Actually, the scenario is just the opposite and the following ETFs could be in focus throughout the new year.
First Trust NYSE Arca Biotech Index Fund (FBT): Barring an alarming reversal of fortune, the First Trust NYSE Arca Biotech Index Fund appears poised to end 2012 as the best-performing major biotech ETF. Assuming no significant change in the landscape, FBT could end the year ahead of the SPDR S&P Biotech ETF (XBI) by over 600 basis points.
However, past performance is no guarantee of future returns. That is worth noting, but it should be remembered that FBT, XBI and the iShares Nasdaq Biotechnology ETF (IBB) offer investors something many other sector funds do not: Immunity. Immunity from the trials and tribulations of Europe's debt crisis. Immunity from slowing emerging markets growth. And some immunity from domestic political wranglings.
The question marks facing biotech ETFs heading into 2013 are what will the new drug approval environment look like and whether or not mergers and acquisitions will pick up.
Market Vectors Coal ETF (KOL): Forgive the puns, which are somewhat appropriate when discussing coal, but it would take a Christmas miracle for KOL to finish the year in the green. That is even with the benefit of an almost 9.5 percent gain in the past month.
Year-to-date, KOL is off 21.1 percent, but the ETF and its constituents got some good news Tuesday when the International Energy Agency said coal will rival oil as the world's top fuel source by 2017. In other words, that means investing in a high-beta, low-dividend sector for the long-term, a proposition that is undoubtedly unappealing to conservative investors.
Is increased coal demand a possibility? Yes. Can KOL perform better next year than it did this year? Well, it cannot do much worse. The other "yes" that needs to be factored into the equation is yes, natural gas prices are still low. The chart of the U.S. Natural Gas Fund (UNG) says as much. That puts pressure on KOL's components to produce and sell more metallurgical coal for steel production in emerging markets. Translation: KOL can move higher if the Chinese and Indian economies support that move.
iShares Dow Jones US Home Construction Index Fund (ITB): One of 2012's shining stars among sector and sub-sector ETFs is the iShares Dow Jones US Home Construction Index Fund. ITB has surged 81.2 percent this year. That run has been buoyed by a steady stream of less bad/decent housing data, including this data point delivered Tuesday: The National Association of Home Builders said its NAHB/Wells Fargo Housing Market index of home builder sentiment jumped to 47 this month from a revised 45 last month. Economists expected a December reading of 47. The December reading is the best since April 2006.
During ITB's ascent, the battle cry of the unknowing has been the ETF is overbought. In reality, every decent dip the fund has endured this year has been a buying opportunity. ITB faces two tests in the new year. First, can the ETF keep moving higher even after an 81 percent gain?
Second, the equity market is believed to be a forward-looking indicator. Theoretically, that means ITB has told investors the housing market could improve in earnest and do so soon. How the ETF responds to a truly bullish residential real estate market remains to be seen.
Market Vectors Gold Miners ETF (GDX): Gold is poised to extend its annual winning streak to 12 consecutive years, but it is doubtful mining ETFs will get in on that act. In other words, barring a significant late-year turnaround, 2012 will be another year in which gold mining ETFs have proven vexing for investors even as gold has moved higher.
Looking to 2013, there are some reasons why investors might find GDX and its components alluring. Decent valuations stand out as one reason. The thesis, albeit flawed, that eventually the miners must start following gold higher is another. Neither is a truly compelling reason to be early to the gold miners. As Citigroup notes, diversified miners such as Rio Tinto (RIO) are offering even better valuations than gold extractors.
Amid rising costs and a rising reputation for frustration and being a group of laggards, gold miners have a lot to prove to investors before this group can be considered anything more than useful as a short-term trade.
Utilities Select Sector SPDR (XLU): Or any U.S.-focused utilities ETF for that matter. There are nine select sector SPDRs ETFs and XLU has been the dog of that group in 2012 with a modest year-to-date loss. Many investors that are aware of the savage repudiation endured by XLU in recent weeks are pointing to fiscal cliff fears as a primary reason for the fund's doldrums.
That is not an inaccurate assessment. Utilities are viewed as a dividend sector and many dividend stocks and ETFs have been punished by fiscal cliff headlines. However, a case can be made that rich valuations have finally caught up with XLU and its holdings, a problem that was highlighted in June.
Even after its recent tumble, XLU has a price-to-earnings ratio of 14.77, which is toward the higher end of the historical range for utilities stocks. To put that in perspective, the Technology Select Sector SPDR (XLK) has a P/E of 12.98.
Financial Select Sector SPDR (XLF): A financial services ETF could not be left off this list, so the group's largest fund was included. Not only is XLF the largest ETF tracking bank stocks by assets, it has also topped its rivals in 2012. To XLF's credit, it has outpaced the Vanguard Financials ETF (VFH) and the iShares Dow Jones US Financial Sector Index Fund (IYF), though all three have generated truly impressive returns.
These ETFs have been helped by Bank of America (BAC) almost doubling year-to-date and Citigroup (C) surging more than 50 percent. In the case of XLF, those two stocks combine for almost 12 percent of the fund's weight.
American International Group (AIG), another XLF top-10 holding and another of the ETF's most controversial constituents, has soared 53 percent this year as well. In other words, in a sector laden with controversial names, XLF is benefiting from the performances of the most notorious financial services firms. Perhaps it will not be on a level that is comparable to what has been seen this year, but a 2013 sequel is possible, particularly if Bank of America does get approval from the Federal Reserve to pay a dividend and repurchase shares.
First Trust NASDAQ Technology Dividend Index Fund (TDIV): One might think the appearance of a new ETF on a list chock full of more established funds is odd, but the First Trust NASDAQ Technology Dividend Index Fund does merit consideration as one of the sector funds to consider for 2013 and the reasoning is quite simple.
Not only is technology the largest sector weight in the S&P 500, the sector is now the fastest-growing in terms of dividends. Assume for a moment that the worst case scenario, that being the fiscal cliff, is avoided. Investors will again embrace dividend stocks and part of theme is finding stocks with potential for stellar dividend growth. Enter cash-rich technology companies such as Microsoft (MSFT), Intel (INTC) and others.
Give TDIV some credit. The ETF debuted in mid-August and has accumulated more than $47.6 million in assets. It has also sharply outperformed Apple over the past 90 days. That stock is not yet a TDIV holding, but it could be at a later date.
FlexShares Morningstar Global Upstream Natural Resources Index ETF (GUNR): The FlexShares Morningstar Global Upstream Natural Resources Index ETF is one ETF that critics of the exchange-traded products industry need to carefully examine because the fund dispels some of the common misnomers about the ETF industry.
GUNR debuted in September 2011 and with more than $671 million in AUM today, the fund is clearly among the top ETFs to have debuted last year. Along those lines, GUNR is proof positive that new ETFs can be immediately successful and that successful new ETFs need not be issued by one of the three largest ETF sponsors.
GUNR also proves that a new sector ETF can enter a crowded arena and provide value to investors. Indeed, there are plenty of energy ETFs on the market today, there are plenty of materials funds and there plenty of funds such as GUNR, which combine the two sectors. With a year-to-date gain of almost nine percent, GUNR has outpaced popular energy ETFs such as the Energy Select Sector SPDR (XLE) and, at the very least, has performed inline with its energy/materials combination counterparts.
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