An All ETF Portfolio? Part 2

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Includes: CAT, EWS, LIT, SPY, XLF, XLI, XLK, XLU
by: Roger Nusbaum

This is a follow up to a post that tried to offer a more constructive reply to the almost useless ETF expert portfolios from Barron’s last weekend. The earlier post was about building an ETF portfolio using broad based products. This will be about using sector based products or using ETFs that might serve as proxies for sectors. As a quick reminder I do not think all-anything is ideal for a portfolio. Assuming no commission constraints I would say the best way to go is to be wrapper-agnostic, to pick whatever you think is the best way to capture each thing you want exposure to.

Our method for portfolio construction at the sector level is to assess the weightings of each of the ten big SPX sectors in the index and then make decisions about whether to overweight or underweight each of the ten based on our knowledge of stock market history combined with what we think is going on now in what is hopefully a forward looking analysis.

The thing that is being managed against is buying each of the ten sectors in an index fund and buying in the same weight as the S&P 500 (NYSEARCA:SPY). No one would buy the ten sector funds in the exact weighting of course but that is the benchmark. In this context we’ve talked most about underweighting financials. This was first done in 2004 due to that sector’s weight in the S&P 500 exceeding 20%; it is a sign of trouble when any sector exceeds 20% of the S&P 500.

Other sector decisions factor in cyclicality. Late in the sector it makes sense to reduce exposure to industrials and increase staples as two examples. Industrials tend to get hit harder than most and staples tend to hold up better than most in the face of an economic slowdown or bear market. These types of simple decisions, and they are simple, need to be done with each of the sectors and the process needs to be ongoing as the cycle is ongoing. This requires time spent to learn about all ten of the sectors and then have the discipline to stick to it.

Our history with Caterpillar (NYSE:CAT) is a great example. We sold it several years ago in the low $70s, bought it back near the market low in the $40s, sold it again in the mid $90s a few months ago thinking that chances of another recession had increased dramatically. Sure enough the stock dropped into the mid $60s very quickly although we did not buy it back on the downswing unfortunately but the thought process is pretty easy to understand. We are no less fond of the name but it is one that goes down a lot when the market goes down.

Now substitute your favorite industrial sector ETF for CAT. The magnitude of the moves may be different but I think the market action is simple enough that the example stands up. XLI is probably going to drop faster than the market on the way down and snap back faster on the way up. Utilities, XLU and several others, will go down less and snap back less—although I will be curious to see if that continues to be the case if a large drop in equities coincides with a meaningful run up in interest rates.

At this point it might make sense to talk about proxies. Just about all the financial sector ETFs are dominated by exactly the banks I don’t want to own. In our case we usually use a common stock or two instead of an ETF even for mid sized accounts where a lot of individual stock positions are not ideal for whatever reason. The search for proxies can include country funds. Many of them are very heavy in financial stocks; Singapore, Colombia, Poland, and Egypt, come to mind as examples. Obviously you have to have researched the country, be favorably disposed to the country and like banks enough to own the fund but EWS will work for someone as a financial proxy. EWS is just an example. As much as I like the country as an investment destination for the fundamentals, when world markets go down a little it seems to go down a lot and when world markets go down a lot Singapore tends to get eviscerated.

Another type of proxy is specialty/thematic funds. For example we use the Water ETF as part of our industrial sector exposure. There are defense contractor ETFs that could also be part of the industrial sector allocation, we use an individual stock for a defense contractor. Something like the Lithium ETF (NYSEARCA:LIT) could be a proxy for materials.

Global X and EG Shares both have sector funds of varying sorts for emerging markets; for China, and Brazil, from Global X and more broadly emerging markets from EG Shares. There are also countless small cap funds for sectors from quite a few different providers to explore.

The idea with this post is not to hand out fish with X% in XLF, Y% in XLK and so on but as noted above in the header the idea is to delve into process. Take little bits of process from various sources and create your own process.