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PowerShares recently listed nine sector ETFs similar to the popular Select Sector SPDRs funds but tracking sectors in the S&P SmallCap 600 index (IJR) instead of those of large-cap S&P 500 (the new funds also have the same ticker symbols with the letter ‘S’ added to the end). For the broad indices we currently favor large-caps over small, and for the most part this is also the case with sector funds: each large-cap sector enjoys a higher ALTAR Score — our measure of an ETF’s overall investment merit — than the corresponding small-cap sector, except for the Energy sector funds (Figure 1). Nonetheless, we think these funds can be quite useful in portfolio construction in two ways:
  • Adjust sector allocation. Many broad small-cap funds, including the iShares S&P SmallCap 600, have sector allocations that are less than ideal. The new small-cap sectors fund can be used to adjust the breakdown to a more desirable balance.
  • Pair trading. For sectors on which we have no strong views one way or the other, a good strategy may be to use a pair trade, long the large-cap sector and short the small, in an effort to profit no matter which direction the sector trends.

We begin with the first. Relative to the S&P 500, IJR is overweight (by 6.6 percentage points) the Consumer Discretionary sector — our least favorite sector at present — and underweight (-8.2%) the defensive Consumer Staples sector (Figure 2). The next two over/underweight positions in are Industrials (+6.2%) and Energy (-5.9%) — our most highly rated sector.

There’s nothing sacred about the sector weights of the S&P 500 and no inherent reason to adjust your small-cap sector exposure to resemble large-cap weightings. But neither should you be relegated to whatever the sector allocation happens to be: one of the advantages of ETFs is the flexibility they allow investors to create precisely the exposure they want.

For example, by simply reducing exposure to the Consumer Discretionary sector by 10 percentage points (to 7.2%) with a short position in XLYS and using that to finance an equal value long position in small-cap Energy (XLES), thus raising the sector’s overall weight in the small-cap portfolio to 14.9%, it would have the effect of boosting the ATLAR Score from 5.9% to 6.5% (Figure 3). Additional modifications could raise the score even more.
Figure 1: ALTAR Scores
(Click to enlarge)

Figure 2: Sector Breakdown
(Click to enlarge)

Another use is to pair a small-cap sector with the corresponding large-cap for which research shows no strong conviction either bullish or bearish. For example, the outlook for the Technology Sector SPDR (XLK) is supported by excellent fundamentals but tempered by rich valuations on some metrics. To elaborate:

  • The recent earnings decline for tech stocks was relatively mild versus the S&P 500, yet the recovery is just as vigorous on real improvements in sales and earnings, not just easy comparisons
  • XLK has an ALTAR Score of 6.7%, somewhat below the 8.3% for the S&P 500 overall, but historically high for the sector, while on a P/E basis it trades slightly above the market (14.0x versus 13.5x 2010E EPS, respectively)
Figure 3: ALTAR Scores
Original vs. modified small caps

(Click to enlarge)

Figure 4: Net profit margins

(Click to enlarge)

While large-cap tech stocks are more profitable throughout the business cycle than their small-cap counterparts, their fortunes appear highly correlated as the chart of net margins illustrates (Figure 5). Return on equity shows a similar pattern between the two segments, and while the small-cap tech sector trades at a discount price-to-book value multiple of 1.8x compared with 2.5x for its large-cap counterpart, our rating methodology implies this is insufficient to reflect the lower profitability, resulting in a lower ALTAR Score (Table 1). Thus, whatever the direction of tech stocks in general, we would expect XLK to outperform XLKS over time. If correct, investors could profit by hedging a long position in XLK with a short one in XLKS, while dramatically reducing risk.

Similar exercises could be repeated with other sectors such as Materials (XLB and XLBS). With an ALTAR Score of 8.2% XLB ranks closely with the S&P 500, but performance going forward is likely to be driven in large part by the future direction of highly unpredictable commodity prices. Hedging XLB with a short position in XLBS could be a profitable trade regardless of what happens to stock prices, if the difference in ALTAR Scores between the two diminishes over time.

Table 1: Calculation of ALTAR Score

Index

Avg. ROE
(A)

Price/Book Value (B) Less: Expenses (C) ALTAR Score (A/B) - (C)
Tech Sector SPDR (XLK) 17.5% 2.5x 21bp 6.7%
Small Cap Techs (XLKS) 9.3% 1.8x 29bp 4.9%

Obviously, investors should not get carried away with such financial engineering of the sort mentioned here or they risk defeating the purpose of index investing. But investors have long used the large-cap Sector SPDRs to add or subtract from the given allocation of the S&P 500, sometimes to great effect such as by “carving out” the tech sector when it burst back in 2000 or the Financial sector more recently. The new PowerShares S&P Small Cap sector funds make the same adjustments possible for the small-cap portion of investors’ portfolios, and their arrival should prove useful even though we don’t currently recommend any of them as stand-alone investments.

Disclosure: No positions

Source: ETFs: Big Roles for Small Sectors