How To Pick A Sector ETF

March 15, 2017

David Haviland, managing partner and portfolio manager, Beaumont Capital Management, Needham, Mass.

We don’t have a “top” sector pick per se—we are continuously analyzing all 10 sectors of the S&P 500 for inclusion. However, we note that three sectors—financials, technology and consumer discretionary—are leading the pack in year-to-date attribution.

Financials has been the big winner since the election. All three of these sectors currently have very low absolute and relative short- and long-term volatility measurements, so we think they show the highest current potential to continue a strong upward trend.

How do we analyze them? The most obvious buy/sell criteria for our sector rotation system is the direction of the trend or the price momentum of each sector. Has it changed? If so, to what extent and how quickly?

All sectors can pause and decline slightly, or move sideways for a while as they determine their next directional move. This is normal market movement. If a trend changes—say, you own a sector and the price trend turns down, or vice versa—how quickly should the system react to this change? BCM uses three additional main inputs to determine the speed of our reaction time:

  1. Volume
  2. Absolute and relative short- and long-term volatility of the sector
  3. Has the trend change come with a sudden increase in volatility levels?

If a sector we own suddenly turns down and does so with high volume, high volatility and a spike in volatility, we want to react sooner rather than later, as price is likely cascading down. However, if volume and volatility are relatively normal and the slope of the decline is gentle, we want to have more patience and wait before we sell as the sector may indeed be just resting.

Sectors, like the markets, have ordinary pullbacks of 5-10% all the time. We don’t want to get whipsawed by these movements, so we have developed and implemented anti-whipsaw rules designed to minimize “less useful” trading and to reduce trading costs.

Now, what ETFs do we recommend? This answer depends on what you are looking for and where you custody.

If your criteria are low tracking error and low cost, the SPDR Sector ETFs are a great choice. If you custody at Fidelity and want the lowest imbedded cost option, then the Fidelity Sector ETFs are even less expensive and currently have most trading costs waived. And if you want to have smart beta infused into the ETF’s process, then we suggest the John Hancock DFA Multi-Factor ETF series.

 

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