Beta Adjusted ETF Performance: Who Really Leads And Lags?

 |  Includes: XLF, XLV
by: Gary Jakacky

When the market makes a sharp move upward or downward, many investors look at the performance of various subsectors (cyclicals, tech stocks, utilities, etc.) for clues about what this suggests about economic performance in the near future. Has the advance been led by consumer staples and health care stocks? These are often refuges for investors fearing a downturn.

Was it lead by cyclicals and consumer discretionary stocks? Bombs away, recovery and bull market gung ho!

One must be careful of overly simplistic analyses, however. Cyclical stocks and financial stocks generally have a higher beta, or sensitivity to moves in the broad market, than sectors such as utilities. Thus, during a market upturn, you would most certainly expect these stocks to outperform the Standard and Poor's 500 index (which, by definition, has a beta of 1.00).

Let me be more precise. Consider the SPDRs Select Financial ETF (NYSEARCA:XLF). This portfolio has a beta of 1.25. What does this mean? Suppose the broad market, as measured by the S&P500, rises ten percent. You would therefore expect the XLF to gain twelve and half percent:

(XLF beta) x (SP500 % change) = expected change in XLF

(1.25) x (10%) = 12.5% expected gain

Suppose during this interval, the XLF actually rose 11%. Yes, it appears to outperform the S&P500. But it did not do so, given the added risk (and therefore better expected return) as measured by beta.

Thus you cannot simply compare a sector ETF's performance against the S&P500 and conclude it has over or underperformed: you must adjust your expectations for risk. I will do so a bit later in this article for the nine S&P500 sector ETFs.

Before that, one issue. While betas for individual stocks are quite volatile, betas for broad portfolios are quite stable over long periods of time. There are several reasons for this. One is simple diversification: the zigs of one stock offset the zags of another. Furthermore, news which makes one company suddenly more volatile (a well blowout for an oil company for example) makes a company in the same industry often appear to be safer refuge.

This is borne out historically, as well. Just to give a few examples, the beta for XLF over the last three, five, and ten year periods has been 1.15, 1.33, and 1.25 respectively. For the Health Care ETF (NYSEARCA:XLV) it has been .65, .73, and .61 over the same spans. While there is some variation, these betas are fairly stable. Thus we can use the historical betas of these portfolios as a reasonable guide for expected performance.

For the purpose of this article we will use the beta for the sector ETFs calculated over the past decade. Doubtless you know this has included periods of bull and bear markets, as well as calm and risky periods.

The market began its most recent advance in this five year bull market on June 24th of this year. Since then the S&P500 has gained 8.9%. Yes, I know there was a brief sell-off in August, largely Syria induced, but this appears to have worn off. We will thus look at the performance of the nine sector ETFs over this summer, comparing them to the SP500 after adjusting the former for their different risks.

Let me show you how I arrived at the numbers in the table below. I will use the XLF as an example. Since June 24th the S&P500 has gained 8.9%; the XLF, slightly more 9.3%. Many analysts will conclude that the Financials had "outperformed" the S&P over this span. But given a beta for the XLF of 1.25, what should we expect the financials to gain in a move like this?

(8.9%) x (1.25) = 11.25%

We would expect this risky portfolio to gain over eleven percent; it did not gain anywhere near that. The financials have not been leaders in the market this summer, they have been laggards.

The table below compares actual ETF performance with expected performance since the rally began late last June. The final column shows over or underperformance.

Risk Adjusted Sector ETF Performance This Summer
ETF actual expect difference
XLY 11.6 8.4 3.2 +
XLK 7.4 8.3 -0.9 -
XLI 8.9 9.8 -0.9 -
XLB 11.3 10.5 0.8 +
XLE 9.5 9.2 0.3 +
XLP 5.0 4.5 0.5 +
XLV 10.3 5.4 4.9 +
XLU 2.8 2.8 0.0 /
XLF 9.3 11.3 -2.0 -
Click to enlarge

Notice that most sectors are fairly close (within one percent) to their expected performance. It shows the point I made earlier: betas are stable and a good guide for the future.

Nonetheless, health care and cyclicals stand put like sore thumbs as strong performers this summer. Should we be surprised, given that nonfarm payrolls and hourly earnings have been ticking upward recently? As Obamacare nears enactment, what is the strength in health care telling us?

Two areas show us information which is at variance with most Wall Street chatter recently. Many people blame rising interest rates for the "underperformance" of utilities. Sure, 2.8% isn't much to write home to mother about. But it is exactly what we would expect, given current market conditions, since XLU has a very low beta of 0.47. The utilities are holding up very well as investments: far better than government bonds, which have drifted almost 5% lower in the last three months.

And even though financial stocks have outperformed the S&P500 in this rally, they are still major laggards when one considers how risky financial stocks are, and the high beta of XLF at 1.25.

Overall this is a very encouraging set of data: the market is being led upward by two very important sectors. Health care/medical technology will be a major industry and employer for the United States and the world in the next few decades. And the strength of consumer cyclicals -- even stronger than it looks, on a risk adjusted basis -- suggest strongly that the consumer is back in good financial shape. Just in time for Christmas!

Disclosure: I am long XLV, IHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.