What To Know About Sector ETF Investing

November 30, 2017

We know that we get narrower, from a sector perspective, when the leading economic indicators decelerate or deteriorate. As the economy gets worse, fewer and fewer sectors actually work. As the economy gets better, more and more sectors work. And right now? We're dead-on average for where are in the cycle.

As we enter 2018, if we expect economic conditions to get better—and I do—then we [should] expect the market will get broader. So, yes, it's true that in 2017 tech dominated, but I think that’ll broaden out. That said, I think technology has a good chance to be a consistent leader into 2018.

ETF.com: What other themes are you keeping an eye on for 2018?

Chisholm: I think the key theme is corporate profits.

In 2015 and 2016, you saw a lot of investors be very cautious. A lot of people talked about lower interest rates, and how that caused high-dividend-yielding stocks, utilities and consumer staples to outperform. But what I saw was a consistent profit contraction without an economic contraction, one that was met by a typical defensive rotation. And corporate profits are what are going to get us out of that.

What you've seen is, in fits and starts from October of last year, a typical rally. Going into next year, I think the question is, can that continue?

Based on the historical analysis I’ve done, I think it can. Average profit recoveries tend to last four years. And if our starting point is the low of the contraction, we could be early on in a durable profit recovery—meaning, thematically, you'll want to skew away from the defensive sectors of consumer staples, utilities, health care and telecom; and [skew] more toward cyclically oriented sectors, like technology, financials, industrials and consumer discretionary.

ETF.com: Recently, iShares launched a new active sector ETF suite that uses artificial intelligence and computer algorithms, which is the most experimental thing we've seen out of the sector space in a while. From your perspective, what room is left to innovate in sector investing?

Chisholm: Sectors are unique; I'd almost call them a unique asset class among equities. It's one of the few ways you can divide up the market and declare exposures—I'm not sure factor [investing] does it, and I'm not sure value and growth [investing] get at it, either.

Innovation is in how you use the building blocks, not what’s in the building blocks. Sectors have great utility at potentially providing solutions. If you're an RIA or an institution looking to mitigate your downside potential, you could buy a low-vol ETF; but another way to do that would be through equal-weighted exposure of defensive sectors. Or, if you believe in the profit recovery, you could buy a high-beta ETF, or you could tilt to cyclical sectors.

From an innovation perspective, we've done a lot, in terms of getting the building blocks already out there. Now we have to turn those building blocks into one of two things: alpha production or solutions to the client. Those are the next steps.

ETF.com: What’s the one thing you wish investors understood better about sector investing?

Chisholm: One dynamic I've felt has been misunderstood is diversification. Sectors are so much more diversified than stocks, and the more diverse your exposure, the more you need to increase your bet size to potentially get the same alpha you'd get if you bet on stocks.

If you're talking about 200 or 300 basis points overweight in a cyclical sector like industrials, that's not going to provide the same potential for alpha as if you owned Deere, Cat and 3M.

You have to be aware of diversification and be comfortable ratcheting up that bet size. Mathematically, it's the same risk/reward, but you have to know that going in.

Contact Lara Crigger at [email protected]

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