Grading ETF Risk: Why Tech, Biotech ETFs Are Half as Risky as Financial Cousins

Seven years ago, you may have opted for the SPDR Select Financials (XLF) as a moderate risk method for acquiring dividends in a “stable” economic sector. In contrast, you may have run screaming from the SPDR Select Technology Fund (XLK) or the iShares Biotechnology Fund (IBB), as “dot-coms” and “drug start-ups” were symbols of the Nasdaq collapse.

Today, standardized measures of risk show that Biotech (IBB) as well as Tech (XLK) present about half the risk of Financials (XLF). Specifically, the popular web portal, “Risk Grades” rates both IBB and XLK as having ”risk grades” of 91 and 89 respectively, while XLF is marked with a 180.

Note: RiskGrades.com developed a standardized method of assessing volatility such that a score of 100 represents the average risk of a globally diversified basket of equities. In effect, if the iShares MSCI All World ACWI Index (ACWI) rates at 100 and the Claymore BRIC Emerging Market Fund (EEB) turns in a grade of 150, EEB may be said to be 1.5x as volatile as ACWI.

Yet having 1.5x or 2x the risk of another investment isn’t necessarily a bad thing. Portfolio risk will depend on how your assets collectively rate. Moreover, if you’re willing to take 2x the risk, you would at least be hoping for 2x the reward.

How did that play out for Biotech (IBB), Tech (XLK) and Financials (XLF) over the last 5 years? Biotech had a 5-year total return of +15%, Tech (XLK) shows a total return of roughly 9% and “2x-the-risk” XLF lost an astonishing -45%. One may have hoped to see a total return of 30% for XLF, as that would be indicative of 2x the reward.

It follows that volatility alone, even standardized volatility, can’t quite account for systemic risk or bear market math risk. Nevertheless, an understanding of how much your investments may oscillate is helpful in constructing your portfolio.

For instance, Emerging Asia (GMF) at a “risk grade” of 140 is not much different than the risk you would take with a broader emerging investment like Vanguard Emerging Markets (VWO) at 136. If you’re a believer in the region, GMF may provide more pop for your euro, yen or yuan.

Conversely, PowerShares Wilderhill Clean Energy (PBW) and Global Solar (TAN) received grades of 172 and 243 respectively, while SPDR Select Energy (XLE) came in at 125. Getting “TAN” for 2x the risk of ordinary energy? I’m only seeing the downside risk without the requisite “2x-the-reward.”

Simply stated, there may be little reason to go with the alternative energy concept. TAN may be a tad too speculative for the volatility involved at this stage.

Full Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. The company may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

Comments

[Alan Young]

Volatility is not the same as risk, unless you are buying at the top.

2009 Sep 24 02:17 PM