3 'Tweaks' That Will Fortify Your ETF Portfolio

by: Gary Gordon

Extraordinary rallies off bear market bottoms are typical. Bullish run-ups in March 2003 as well as March 2009 registered enviable unrealized gains of 35% and 65%, respectively; each advance experienced little resistance for roughly nine to 10 months.

Powerful moves off minor corrections are less typical, if not downright suspicious. Investors in the S&P 500 SPDR Trust (NYSEARCA:SPY) since mid-November have witnessed a soothing 22% ride to all-time highs in just seven months. In the last quarter century, you could probably count the number of times on one hand when U.S. stocks traveled a similar vertical trajectory for more than half a year without a significant hitch or pullback.

Regardless of the reasonable nature of current valuations, there are plenty of reasons to doubt the slope of the movement. For example, equities have outshined comparable bonds by nearly 7% over the last four weeks -- a feat that is particularly flashy for the prior two years. Similarly, several high-yield bond (aka "junk") indexes show a modest 2.6% in additional yield over comparable treasury bond funds; the spread is more reasonable when it is greater than 3% (300 basis points).

It follows that sensible ETF enthusiasts might consider "tweaking" their holdings. Here are three moves that would lower portfolio risk yet maintain a desirable level of reward for that risk:

1. Lower the average maturity of your high-yield bond ETF. Both iShares High Yield Corporate (NYSEARCA:HYG) and SPDR High Yield Bond (NYSEARCA:JNK) have been terrific in the modern era of quantitative easing. Both of these vehicles hold corporate bonds with average maturities in the sweet spot of the Federal Reserve's bond-buying program (i.e., seven years). On the other hand, the Fed is beginning to hedge its public statements such that perhaps the central bank will begin to taper the money printing and subsequent bond purchasing. While I don't believe that this will actually be the case in 2013, it is certainly possible. And if the Fed does begin to taper one should expect intermediate- and longer-term treasury yields to rise, pressuring comparable high-yield corporate bonds.

The answer? Reduce HYG and JNK exposure, downshifting into PIMCO 0-5 Year High Yield (NYSEARCA:HYS) or SPDR Barclay Short-Term High Yield (NYSEARCA:SJNK). The annual dividend yields that are paid out monthly are only slightly less than the big brothers, but one would have less concern with respect to significant capital depreciation.

2. Shift away from an all-market-cap-weighted portfolio. If you have invested in the ever-popular SPDR S&P 400 Mid-Cap (NYSEARCA:MDY), you may have a great deal to crow about over the last 12 months. Owners of MDY have 27% unrealized profits on a year-over-year basis.

However, as the bull market rally has strengthened a number of savvy individuals have started to shift their attention to funds that track different types of indexes. For instance, WisdomTree Mid-Cap Dividend Fund (NYSEARCA:DON) tracks a fundamentally weighted index that measures the performance of mid-caps of the U.S. dividend-paying equities. Dividend stocks tend to hold up better in down markets as well as sideways markets due to the fact that fewer people sell their income producers. What's more, the relative strength of DON over MDY has increased in recent weeks.

3. Disregard sector rotation hype by adding to your defensive equity ETFs. It's as if some analysts are getting cocky about the state of market affairs. While noting that defensive non-cyclical stock sectors (e.g., consumer staples, healthcare, telecom, etc.) have been the best performers between the year's inception and April 15, a better-than-anticipated showing by cyclical segments (e.g., energy, industrials, materials, etc.) in the last month has many declaring that a rotation into economically sensitive sectors is under way.

The problem with the hype is twofold. For one thing, even the best bull markets take breathers. When that happens, the cyclical sectors are almost certain to take a bigger shot to the jaw then staples-heavy funds like WisdomTree Equity Income (NYSEARCA:DHS) or healthcare-dominant iShares High Dividend Equity (NYSEARCA:HDV). Second, the Relative Strength Factor (RSF) scores for various segments across the last 10 weeks demonstrate that traditionally defensive segments have been increasing their momentum scores, whereas the economically aggressive sector ETFs have been fading.

You're Going To Buy The Aggressive Risk Sectors Now?
RSF Score 02/14 RSF Score 05/13
Aggressive (Cyclical)
SPDR Select Financials (NYSEARCA:XLF) 89.7 88.5
SPDR Select Industrials (NYSEARCA:XLI) 72.0 64.3
SPDR Select Energy (NYSEARCA:XLE) 71.9 51.7
SPDR Select Materials (NYSEARCA:XLB) 59.2 49.5
Defensive (Non-Cyclical)
SPDR Select Health Care (NYSEARCA:XLV) 75.9 90.4
SPDR Select Consumer Staples (NYSEARCA:XLP) 58.1 75.5
Vanguard Telecom (NYSEARCA:VOX) 49.4 79.4
SPDR Select Utilities (NYSEARCA:XLU) 37.9 52.8

To the extent that you've been persuaded that now is the time to jump into manufacturing-oriented materials or global-growth-oriented energy, rethink the premise. Then consider lightening up your portfolio's exposure. In contrast, if you require more stocks in your basket, be patient for a pullback on the defensive segments. I like HDV with its dividend-plentiful pharmaceutical companies and global telecom giants. Personally, I would probably wait for a pullback to the 50-day trendline.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.