ETFs: The 2.0 Version Of Sector Rotation

February 10, 2015

 

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today’s article is by Hafeez Esmail, San Francisco-based Main Management’s director of compliance.

 

In investment management circles, it’s a well-known adage that it’s better to own the worst stock in the best-performing sector than the best stock in the worst-performing sector. In most cases, this holds true, and it underscores the fact that identifying the correct segment of the market at the right point in the investment cycle is of critical importance.

Prior to the advent and proliferation of ETFs, sector rotation strategies were populated using single stocks. Executing the strategy with individual positions was challenging, as you have to get two decisions right:

 

  1. Correctly identify the right sector
  2. Select the right handful of stocks that best replicate the capital-weighted performance of that particular GIC sector

 

Given that the challenge involved mastering multiple disciplines, there were precious few managers that could consistently execute on both fronts.

 

ETFs Make It Easier

The onset of ETFs did simplify the process in that pinpointing the right sector was the key exercise. State Street was first to market with the S&P GICS Sectors, all of which currently have sizable trading volumes. iShares and Vanguard have built out sector suites as well, expanding the tool kit beyond U.S. markets.

 

However, there are some new wrinkles to consider. First Trust has a proprietary methodology—incorporating fundamental factors—to construct sector ETFs, many of which have outperformed the standard capital-weighted GICS sectors.

 

Moreover, there are technology subsectors such as software or semiconductors, and health care subsectors such as biotechnology. All of these fund sponsors have ETFs with deep and liquid trading, and provide an efficient way to overweight particular segments of a given sector that may have greater price appreciation than the overall sector.

 

ETF asset managers are essentially active managers of passive index ETFs. The goal of each is to generate outperformance over a given benchmark. For sector rotation strategies predominantly focused on U.S. large-cap stocks, the benchmark that most managers seek to outperform is the S&P 500 Index.

 

Allocation Choices

There are different approaches to try to outperform the benchmark. Firms using fundamental analysis—such as my firm, Main Management LLC—seek to pinpoint undervalued sectors/subsectors and seek out a catalyst that should propel that sector to revert to its mean. We express these findings by overweighting favored sectors.

 

That said, you can also eliminate unfavorable sectors. As an example, Main Management’s U.S. Equity Sector Rotation Strategy opted not to own any energy exposure in 2014. It was one factor that allowed the strategy to be among the 20 percent of active managers that beat their benchmark in 2014.

 

The other well-known approach to sector rotation is tactical management. These are firms that use either technical or proprietary signals to rapidly move in and out of sectors, and potentially move out of the market altogether.

 

Some of these approaches have been highly successful during certain periods (including the 2008-09 recession), but many of those have had less-than-favorable outcomes where there has been no downturn.

 

While tactical approaches may have their merits, being tax-aware is typically not one of them. While a fundamental manager generally has more judicious turnover, this can have appealing outcome on an after-fee, after-tax basis. The rapid signal changes of tactical models tend to generate predominantly short-term gains and losses from a tax perspective.

 

In summary, it’s important to recognize that sector rotation has evolved from its single-stock world to a generally more efficient—and, one may argue, more effective—model when implementing an investment outlook using ETFs. A fundamental manager, in general, may outperform or underperform the benchmark, but typically it will not be by significant margins, but may be more consistent.

 

Tactical models may have more dispersion in their outcomes, where results may vary from feast to famine.

 

Which one is best for a given client? The answer may lie in whether one is seeking a more uniform core portfolio (relative to a benchmark) or one is seeking greater potential upside but is willing to accept greater deviation from a given benchmark—both favorable and unfavorable. A fundamental manager may be better suited to the former, and a tactical approach to the latter.


A pioneer in managing all-ETF portfolios, Main Management LLC is committed to delivering transparent, cost-efficient and customized investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency. For more information, see http://www.mainmgt.com>.

 

 

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