ETF.com: Because of the outlook of higher rates or because it should recover from a weak performance this year?
Stein: It's one of the worst-performing sectors this year. It’s uncertainty on what's going to be happening with rates, the election, and a little bit of the black eye the industry has gotten as a whole. But when I look at fundamentals, and I look from an earnings perspective, where it is from a contribution to GDP, where it is from employment trends, we see tremendous growth and upside potential in the financial sector. So, we're overweighting that sector.
ETF.com: What other sectors do you like for 2017?
Stein: Another poorly performing sector recently is health care due to uncertainty from the election and valuations that got a little long in the tooth. I see the health care sector as another place I would want to overweight in the upcoming quarters.
Basic industrials have had a good run, but the strength of the dollar, the valuation component of that, will also be a head wind for industrials, so I would reduce exposure there. The same applies to materials. The dollar and a run-up in material prices—gold particularly—have skewed that sector, and I'd be very, very cautious in materials going forward.
ETF.com: What fundamental metrics or factors do you look at to decide when it’s time to jump in and out of a sector? How do you build a sector rotation strategy?
Stein: In our sector rotation portfolio, we have a core holding of large-cap, midcap value growth—that's somewhat static. We then use sectors around it based on where we're seeing economic fundamental growth. We increase and decrease the sector allocations based on economic fundamentals.
If a sector is contributing more to the economy, we want to be in that sector. If the sector’s adding more jobs, we want to be in that sector. And then momentum is the confirming data point. You like to have all these things occurring, plus positive momentum. Or, at least if it’s negative momentum, it's waning and it’s starting to trough. Lastly, our economic fundamentals of the economy as a whole will lead us to adjust the weighting.
ETF.com: Is sector rotation a good way to tackle the equity part of a portfolio? I’ve seen research that says sector rotation strategies offer little in added returns over time. Should you invest through a sector lens?
Stein: It’s a good addition. If you only care about long-term returns, you could just leverage up the S&P 500 and close your eyes. I do caution that if you do that, you might lose all your money. The volatility in the S&P 500 might be something you’re uncomfortable with.
Additionally, there will be times like 2001 recession, when there were sectors that went up. Small-cap went up, REITs were up, financials held up OK. It was very different in the 2008 recession. So, when you make a portfolio of risk assets, having sector rotation as a component of that is very important, because the market will appreciate over time for different reasons. There will be times that a sector will be carrying the market, or a sector will be harming the market, and you’ll have this market performance that you could do better than by identifying the strong and weak sectors.
What you're seeing now is not so much deviation from that, but there are periods of time where having sector allocations really is beneficial to the risk and return of the portfolio.
ETF.com: Has sector investing changed in the last decade? Are correlations out of whack? And are different products today—such as smart-beta ETFs—impacting the way people invest in sectors?
Stein: The ETF itself has allowed you to get pure exposure to a sector in a way you couldn’t before. You'd have to buy baskets of stocks and then decide where you’d put this or that stock. Is it really fish or fowl? I don't know. Now, you have ETFs that truly mimic a sector’s indices without having to buy or pick the individual stocks. That’s to say sector investing has become a lot easier to do today.
The basic research to determine whether a sector is likely to outperform or underperform hasn't changed. Basic economic fundamentals make sense—more people working, producing more output, that's good. We all work for a profit. I'm assuming that if you're making a profit, you're going to try to do more of that. That hasn't changed.
What has changed is the profile in a low-return environment of outperforming and underperforming sectors. I don't think it’s a permanent change, but when you're in an environment where 2.5% seems like a lot greater performance that 1.9%, what constitutes a winner has changed. We need to be mindful of what the long-term objective is.