Capturing a Sector: ETF or Individual Stocks?

by: Roger Nusbaum

Reader BillB left a question about the notion of "buying the best" within a sector and forgetting about sector ETFs. He says he has heard many talking heads say this in a matter of fact way, but he doubts it is as easy as they say.

He further asks me if the stocks I hold are "the best" and if I compare stocks I use to their respective sectors to measure performance.

There's a lot here...

"The best" is for me an incomplete description. I think of it more in terms the best way to capture a desired effect or narrow theme. At different points in the cycle, the best way to capture certain things will change. Using financials as an example, I have disclosed being underweight and own foreign, high yielding banks in an effort to reduce volatility in a sector I expect to struggle.

When the yield curve goes right side up the best way to build exposure will change. Adding volatility and more domestic exposure will make sense at that point, whenever it comes.

The market is always changing, but it doesn't change so fast that you need major portfolio upheaval every quarter. As it changes slowly over time (the yield curve being a good example), portfolio changes need to be made.

I believe in top down portfolio construction, which means that getting the sector right is more important than stock selection. Obviously this won't be the case 100% of the time, but it is right often enough for me. So owning a sector ETF as a proxy for a sector (for those that construct their portfolios at the sector level) is not a bad idea. In terms of short term results, it seems fairly obvious that at times a stock would be the better choice and at other times the ETF would be better.

There are some stocks that can be bought and probably held forever. Anyone think buying an appropriate amount of Johnson & Johnson (client holding) is a reckless idea? It won't always be the best stock, but over time it goes up and increases its dividend. There are other stocks like this. If you own a portfolio with a bunch of names like this, you still need to pay attention as a couple of them will need to be sold at some point, but most will not. I'm sure one-time Dow component American Twine was a "hold forever" type of name in its day.

However, if all you own are "best of breed" you probably don't have a properly diversified portfolio. Being diversified has to include small cap, emerging market and perhaps a lottery ticket idea. Maybe this is where ETFs can come in.

As far as measuring performance at the sector level, I'm not sure I have a useful answer. I know what stocks are doing well or are struggling at any given time, but struggling does not always mean the same thing. Going back to financials, only one bank that I own is making new highs. The rest, like most of the sector, are struggling. They've bounced some, but this is a bad time for the sector. The important decision was made months ago - to be underweight the sector.

If I owned an oil stock that was really lagging the sector (I don't, but there must be some), I might consider getting rid of that one. This has been a great few years for energy stocks. A stock that had not participated in that would seem to have something wrong even if I couldn't figure out the problem.

In reading emails and comments, meeting and talking to other money managers and the feedback we have received from clients, I have come to learn that my approach to building and managing portfolios has a lot of subtleties embedded which can be difficult to articulate. The subject matter of this post might fall into the "difficult to articulate" category.