Sector ETFs and Single Country ETFs Can Boost Returns

 |  Includes: EFA, EWZ, FXI, IXC, IYW, SPY
by: Roger Nusbaum

Roger Nusbaum submits: Herb Morgan, who is a contributor to Seeking Alpha, was on CNBC yesterday talking about some of the flaws of ETFs. First of all, kudos to Herb for the interview (I am not being sarcastic).

As is often the case, I find myself disagreeing with his conclusion. You should decide for yourself.

The general tone of the interview was the he does not believe that sector ETFs are necessary, nor are single country ETFs. A part of the equation is that there are tracking errors in the narrower ETFs. That there are tracking errors is not really debatable, he is right. I concede all of the things that he says cause those tracking errors, like liquidity and constraints of position size within a fund.

The largest tracking error mentioned in the segment was 103 basis points; there could be ETFs out there with even larger tracking errors. For the sector ETFs, Herb said the largest tracking errors were 65 basis points.

I wonder whether the consequence of the tracking errors matter. I don' t think they are so important as to make these ETFs a bad idea.

Long time readers may know that for some accounts I manage I use a mostly ETF allocation (not my first choice, but size constraints sometimes apply). In those instances I use sector ETFs to try to recreate what I do in accounts where I use mostly stocks (most accounts).

A do-it-yourselfer may not want to make ten sector decisions, understood. Year-to-date, though, making sector decisions with two sectors and being equal weight the other eight could have yielded a noticeable result. If you are involved enough in your investments to know about a site like this, I assume you are capable of and interested in making at least a couple of active decisions. I think overweighting energy by 5%, underweighting tech by 5% and going equal weight all other sectors was not too complex as to be unrealistic.

By my math and the chart above, using sector ETFs that I own for clients, you add 100 basis points to your YTD returns. In a $100,000 portfolio an extra 5% in energy would add $750 YTD and that 5% not in tech would have been spared $250 of loss. I do not know the tracking errors of IXC or IYW but the returns on the chart are net of errors and fees.

I view this as one decision. You may view it as two. Either way, it added 1% vs. the market YTD. Would this type of trade be beyond your scope? Again, for most people inclined to seek out stock market blogs I would say no.

Herb said that owning EFA captures the foreign markets; he does not believe in the single country products. Are you close enough to the markets to know about what is happening in China or Brazil? Again, these are two countries that are not off the beaten path. If you are reading this post I don't think it is a stretch to think you have exposure to one of these places.

The blue line is China (I own that ETF personally) and the yellow line is Brazil. If an investor, not looking to do a lot of work, put 90% of his foreign portfolio into EFA (the black line) and 10% into Brazil he would again add about one percentage point to the return for the foreign part of the portfolio.

Like the example above, this represents one decision. I do not believe this example is unrealistic either. For investors willing to make more decisions than this, and assuming they get some wrong, I believe the narrower themes could absolutely add value and be worth pursuing.

I feel very strongly about this sort of thing. Also, I am fully aware that the funds and ideas cited in the piece are not for everyone but they offer utility in the context of a diversified portfolio for the right type of investor.

Bottom line: you need to decide for yourself.