Are Sector ETFs Good Hedges?

June 28, 2012

Goldman released a research note recently on the pitfalls of using sector ETFs as a hedge that made too much of very little.

The note, a little overly concerned in tone, made two points: First, sector correlations are high—sometimes in excess of 70 percent; and second, sector ETFs don’t make perfect hedges.

I’d like to dig into both those observations, because neither is particularly worrisome to me.

Take sector correlations. We worked on this last year and found very similar results: Most sectors of the economy are indeed highly correlated with each other. This isn’t news to anyone who has been paying attention to sector research and, intuitively, it makes sense.

Think about it: Sectors are simply segments of the market painted in broad brushstrokes. Often, they’re affected by many of the same macroeconomic factors. Is it a surprise that utilities respond to some of the same economic inputs as industrial firms?

With rising correlations in the market in general over the past years, sectors are bound to be intercorrelated as well. The Goldman piece showed that correlations of sectors to the broader market also tend to be high over a three-year period. But again, this is nothing new.

The second point the note makes, that using sector ETFs as a hedge isn’t as effective as investors assume, is a little more interesting.

The thrust of Goldman’s research is that hedging one portfolio with a different portfolio, like a sector ETF, doesn’t make a perfect hedge. It can, in fact, increase your relative exposure to some stocks.

While this is certainly the case, it doesn’t strike me as particularly newsworthy.  If investors are truly assuming—without digging into the holdings of these funds—that their sector ETFs will somehow perfectly hedge their sector exposure, then Goldman is doing them a service.

Frankly though, the mechanics behind it really shouldn’t come as a surprise to anyone.

Despite the generally negative tone of the Goldman piece, I still believe that sector ETFs do their jobs well, delivering the returns of their respective industries, often holding broad portfolios at low fees.

Granted, those industries often respond to many of the same inputs, but that’s simply the way the cookie crumbles.




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