How I Use ETFs To Capture Sectors and 'Secondary Effects'

Roger Nusbaum submits: A reader sent an email asking for an update to an ETF portfolio that I wrote about previously. I think he was referring to a post from June 27 that you can read here.

I need to disclaim that this type of thing is not my first choice for any portfolio. Please keep that in mind as you read this -- that this is not my best suggestion to anyone.

The starting point for me for portfolio construction is how I want to weight the sectors. Right away this means that the large/mid/small cap ETFs are off the table for me. As I wrote last week, I am convinced that value can be added by making active decisions with all ten S&P 500 sectors. At this point let me concede all the flaws that go with using the S&P 500 as a benchmark, but it is what I use.

For the do-it-yourselfer willing to learn about what sectors usually do well at different points in the economic and stock market cycle, catching the really big themes -- like tech in the late 90s (kept in reasonable proportion) or energy and commodities in the last couple of years -- can add measurable value to their results without being correct about any stocks or taking single-stock risk. Adding individual stocks could either help or hurt returns depending on some combination of skill and luck (don't underestimate luck's importance).

A great resource to know how the benchmark of your choice is weighted for sector is to look at the iShares fund that mimics your benchmark at the iShares website. The financial sector comprises about 21% of the S&P 500. An inverted curve means that lending is unprofitable. If lending is unprofitable, it is not a stretch to think that financials will struggle. That has been my thinking -- and for the last month or so it has been wrong. I target that sector at about 15-16%. The stocks have been doing well (actually most of my exposure is in foreign banks from Canada, UK, Australia and Ireland). The important point is that the consequence for being wrong is almost nil because I have not made a big bet.

There are sector ETFs from iShares, StateStreet, Vanguard and PowerShares. Some of the other providers (First Trust comes to mind) have the occasional sector ETF here and there. Given my preference for foreign, I use the iShares Global ETFs where available. Given the myriad of unique client circumstances, I have exposure to all the Global ETFs for at least one client, not the same client mind you, but spread across our practice.

The global sector ETFs include Financials (IXG), Health (IXJ), Energy (IXC), Telecom (IXP) and Tech (IXN). There is no such fund for the Industrials, Utilities, Staples, Durables or Materials. WisdomTree has ten sector ETFs in the registration pipeline that will have global exposure.

I do use the occasional narrow-themed ETFs as well. I have been most public about my exposure to the PowerShares Water ETF (PHO). The theme of water seems very obvious to me. As a secondary effect, I view PHO as a way to get smaller cap exposure in the industrial sector as PHO is 57% industrials, and the average cap size of the fund is $10 billion. All of the narrow ETFs offer the potential for a secondary effect. You may not want or need the secondary (or primary) effect of a given ETF, but the potential is there.

Another example of this is the IPO ETF (FPX). FPX is a decent proxy for small cap growth.

The notion of ETF secondary effects is not something I have read anywhere else, so I may be an island, but I think this is a very important benefit to the product and can help do-it-yourselfers isolate some very narrow effects without single stock risk.

Comments

[John Heneghan:]

Roger,

Thanks for this interesting post about portfolio construction and sector allocations in which you use the S & P 500 as the benchmark. At the other extreme, there was an interview in Barron's this week with David Richards, former money manager at Capital Research & Management and PrimeCap.

The article indicated that "Richards is braced for calamity." He is anticipating rising inflation and an uptick in short rates which could create a financial crisis. His long portfolio is 50% oil, 30% gold, 11% Microsoft, 4% Berkshire Hathaway and 3.5% Russia.

I viewed Richard's portfolio as "betting for calamity" more than "bracing" for such potential risks. I would be interested in your thoughts on Richard's contrarian economic forecasts and portfolio construction.

2006 Aug 21 09:29 AM

[Roger Nusbaum:]

I read the interview, natch, and it was interesting. I've been mulling whether to write about it or not. For now, it is clear that his potfolio is not diversified. Assuming he makes no changes he has more riding on his being right than I would ever structure in portfolios I manage.

Of course he can do this because (not being sarcastic at all) he is much smarter than me and most other folks.

Also he is probably much better equipped to handle the volatility that goes with <em>being wrong</em> for a few days at a time like last week than most investors.

2006 Aug 21 10:42 AM

[ETF Guy:]

"The important point is that the consequence for being wrong is almost nil because I have not made a big bet."

Doesn't this also mean that the consequence of being right is also almost nil?

The article started off with an argument about how targeting sectors can improve returns, but you lost me with the above statement. No one is going to be right all the time, but if being either right or wrong is going to have no effect, then why not just stick to a broader index?

2006 Aug 22 06:28 PM