Build Your Own Hedge Fund with Sector ETFs

by: David Jackson

Exchange-traded funds (ETFs) are changing the investment landscape, and that's why they're growing so fast. ETFs allow long-term investors to build truly diversified portfolios from low-cost index funds in any brokerage account, whereas previously investors would need to operate multiple accounts or move their account to a low-cost provider. More important, ETFs can be sold short; and that means that regular investors can effectively run their own hedge funds.

Regular investors run their own hedge funds??? That sounds ridiculous.

After all, hedge funds are often described in the financial press as "exotic", "unregulated", "high-risk" or "for the wealthy".

But there are strong reasons why regular individuals may want to hedge their ownership of stocks and bonds. For example, many people think the U.S. stock, bond and real estate markets are in for a tough decade due to valuations, rising
interest rates, risk of inflation/deflation, the budget and trade deficits and inflated asset prices. If they are correct, regular investors may want to reduce their exposure to the market while still striving to make money.

Jack Ablin, the chief investment officer of Harris Private Bank in Chicago, wrote in this weekend's Barron's (subscription required) that over the last 15 years the average return differential between the best-performing and worst-performing sectors of the S&P 500 has approached 50%. That means that investors can generate significant returns by betting correctly that some sectors will outperform others, irrestpective of the performance of the overall stock market. Sector ETFs make it easy to do this.

Mr Ablin's Barron's article outlined his predictions for 10 sectors that comprise the S&P 500. So here's what I'm going to do: in this post, I'll summarize his sector views. Then in subsequent posts I'll show how an investor could implement those predictions in different ways using sector ETFs.

Jack Ablin's sector views

Mr Ablin ranks the 10 sectors that comprise the S&P 500 "in order of their appeal". Sectors are numbered 1-10 in order of attractiveness, and the relevant sector ETF is given for each sector:

1. Health-care - ETF ticker: XLV
Overweight. Valuation is reasonable (forward P/E of 18.8, an 18% premium to the market's P/E, versus a sector P/E of 25 and a 30% premium a year ago). Sector is defensive (relatively stronger in a weakening economy). Does well in inflationary environment as health-care companies enjoy pricing power.

2. Telecom - ETF ticker: IYV
Overweight. 4% dividend yield and stable earnings growth are changing investor perception of the sector. Sector is defensive due to predictability of earnings. Valuation historically cheap at P/E of 15.3. Momentum due to 2.7% outperformance of the S&P 500 in April.

3. Utilities - ETF ticker: XLU
Overweight. 3.3% dividend yield. Defensive sector in slowing economy. Insulated from higher energy costs (they're passed on to customers). Utilities outperform one year after interest rates start to rise. Negatives: forward P/E of 15.9 is at a 15-year high.

4. Financials - ETF ticker: XLF
Market weight. Very cyclical. Sector is expensive relative to historical average 25% discount to the S&P 500. Rising credit spreads could negatively impact stocks.

5. Basic materials - ETF ticker: XLB
Market weight. Negatives: sector is cyclical as earnings are tied to commodity prices; strong recent performance (13% in 2004) reduces outlook going forward.  Positives: "trading in the bottom third of their valuation range, at 13.8 times forward earnings"; sector thrives as the yield curve flattens.

6. Consumer staples - ETF ticker: XLP
Market weight. Positives: current valuation premium to the S&P 500 of 15% is lower than the historical norm of 20%. Defensive in a slowing economy relative to retail sales.

7. Energy - ETF ticker: XLE
Underweight. Outperformed the S&P 500 by 30% over the last 12 months. If the Fed raises interest rates above the inflation rate, commodity prices  - including oil - will fall. Relative valuation (20% discount to S&P 500 based on forward earnings) reasonable, but recent earnings growth of 60% likely unsustainable and forward earnings may be overestimated.

8. Technology - ETF ticker: XLK
Underweight. Suffers most from rising energy prices. Highly cyclical and leveraged to consumer confidence and industrial production. Cyclicality only gradually being appreciated by investors. Positives: cheap on a relative basis compared to historical norms, and benefits from falling dollar.

9. Industrials - ETF ticker: XLI
Underweight. Valuation expensive as now trades at premium to the S&P. Industrial
companies are capital intensive, so suffer from widening credit spreads. Highly cyclical.

10. Consumer discretionary - ETF ticker: XLY
Underweight. Sales growth likely to faulter. Suffers from decling dollar. Susceptible to weakening consumer confidence and flattening yield curve. Negative stock price momentum after prior outperformance. Postive: valuations reasonable, particularly for retailers.

An important note about these ideas: they're controversial and may be wrong. Will the telecom sector enjoy "stable earnings growth", for example? I'm not
sure. Free voice over IP calls and the entry of the cable companies into the voice market are highly deflationary for the telecom sector, and it's hard to see how earnings will be unaffected.

But assuming you agree with Mr Ablin's sector ranking, I'll show in the next few posts different ways to implement it with sector ETFs. Update: the first portfolio based on Mr Ablin's sector views is here.