Tilt This Way: Non-Cyclical Sector ETFs Should Be Used To Optimize Portfolios In 2017

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Includes: EFAV, FHLC, FSTA
by: Reason Investments

Summary

The forward-looking earnings yield of U.S. cyclical stocks is now only 50bp higher than that of non-cyclical stocks, by our estimate, with considerably more risk.

The ratio of cyclical equity to non-cyclical equity is roughly 2 to 1 for most broad-based large-cap stock ETFs, requiring the addition of non-cyclical sector ETFs to adjust portfolio risk.

We like FSTA, FHLC, FCOM and FUTY for U.S. non-cyclical exposure and IPS, IRY, IST, and IPU for foreign-developed non-cyclical exposure.

Non-cyclical sector ETFs should take on a larger role in portfolios as 2017 begins with an aging bull market. This conclusion is derived from our analysis of over 1,000 large-cap company stocks underlying the ETFs in our coverage universe. For each company, we compute an estimate of average future annual EPS based on each company's current invested capital and its recent history of capital returns. This approach enables us to adjust EPS projections for cyclical factors that may affect near-term results (e.g., energy stocks). Such quantitative analysis is often insufficient for individual stock forecasts, but becomes more powerful as we aggregate hundreds of company earnings forecasts into a few asset classes.

We grouped companies into four large-cap equity asset classes: U.S. non-cyclical, U.S. cyclical, foreign-developed non-cyclical, and foreign-developed cyclical. The non-cyclical asset classes include companies in the consumer staples, health care, telecom, and utilities sectors. All other companies are included in the cyclical asset classes. We used our earnings projections to compute a forward-looking earnings yield for each asset class as shown below.

Earnings Yield

U.S. non-cyclical

4.9%

U.S. cyclical

5.4%

Foreign dev non-cyclical

4.8%

Foreign dev cyclical

6.1%

Cyclical asset classes still offer a greater earnings yield (and a greater expected return if we use earnings yield as a proxy for future return) than non-cyclical asset classes. However, the higher risk of cyclical stocks makes non-cyclical holdings much more attractive on a risk/reward basis. Our portfolio optimization model now suggests that the typical portfolio should allocate nearly twice as much weight to non-cyclical equity vs. cyclical equity. We recommend that the average investor should put 43% of their portfolio into non-cyclical equity and 26% of their portfolio into cyclical equity.

Source: arcpointadvisor.com

Most broad-based large-cap stock ETFs tilt roughly 2 to 1 in favor of cyclical equity, requiring the addition of non-cyclical sector ETFs to bring the portfolio in line with our recommendation.

Our model recommends the following equity portfolio:

ETF name

ticker

% weight

Fidelity MSCI Health Care Index ETF

FHLC

9

iShares Core MSCI EAFE ETF

IEFA

8

Fidelity MSCI Consumer Staples Index ETF

FSTA

8

SPDR S&P International Health Care Sector ETF

IRY

7

SPDR S&P International Consumer Staples Sector ETF

IPS

6

Fidelity MSCI Consumer Discretionary Index ETF

FDIS

3

Fidelity MSCI Telecommunications Services Index ETF

FCOM

3

SPDR S&P International Financial Sector ETF

IPF

2

iShares Edge MSCI Minimum Volatility EAFE ETF

[[EFAV]

2

SPDR S&P International Telecommunications Sector ETF

IST

2

Fidelity MSCI Financials Index ETF

FNCL

2

Fidelity MSCI Information Technology Index ETF

FTEC

2

Fidelity MSCI Utilities Index ETF

FUTY

2

SPDR S&P International Consumer Discretionary Sector ETF

IPD

2

SPDR S&P International Technology Sector ETF

IPK

2

SPDR S&P International Utilities Sector ETF

IPU

2

SPDR S&P International Industrial Sector ETF

IPN

1

Fidelity MSCI Industrials Index ETF

FIDU

1

Fidelity MSCI Energy Index ETF

FENY

1

SPDR S&P Emerging Markets Small Cap ETF

EWX

1

SPDR S&P International Energy Sector ETF

IPW

1

SPDR S&P International Materials Sector ETF

IRV

1

Four of the top five equity ETFs recommended by our model are non-cyclical sector ETFs. Fidelity MSCI Health Care Index leads the list with a recommended portfolio weight of 9%. This ETF is designed to track the MSCI USA Investable Market Index (IMI) Health Care. Although it is an all-capitalization index, large-cap stocks (defined here as having a market cap above $6.5B) account for nearly 90% of the index weight. The majority of the index is comprised of pharmaceuticals and biotechnology companies. Drug pricing concerns persist (a major reason why FHLC fell 3% in 2016), but FHLC should be relatively insulated from any downward shift in the economy. And with an expense ratio of only 8.4bp, investors are not paying a lot for this portfolio risk dampener.

Source: MSCI, Inc.

Our other favorite non-discretionary sector ETF is Fidelity MSCI Consumer Staples Index ETF with a recommended portfolio weight of 8%. This ETF is designed to track the MSCI USA Investable Market Index Consumer Staples. Approximately 94% of the index weight is in large-cap stocks. FSTA returned 6% in 2016, but like FHLC, it too lagged an overall U.S. stock market that has been in "risk-on" mode since the November U.S. elections. Its expense ratio also is extremely low at 8.4bp.

Source: MSCI, Inc.

Notably, our model equity portfolio recommends very little allocation to minimum volatility ETFs apart from a 2% weight in iShares Edge MSCI Minimum Volatility EAFE ETF. Minimum volatility ETFs are an increasingly popular "smart beta" strategy for controlling portfolio risk. However, our model demonstrates a strong preference for using sector ETFs to manage equity risk. Even though minimum volatility ETFs have a tilt toward non-cyclical equity, cyclical stocks are still a large proportion of the total holdings in many cases due to sector weighting constraints, and the expense ratios for many passive U.S. sector ETFs (such those offered by Fidelity and Vanguard) are below those of any minimum volatility funds. We caution that these recommendations may not be optimal for investors that make frequent changes to their portfolios as sector ETFs tend to have higher bid-ask spreads than the most liquid broad-based ETFs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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