Active Indexer: Offense–Defense, Part II

August 07, 2007

In part II of a series, Serrapere considers new approaches to handle the increasingly risky market.

The S&P, SPXEW and RAFI exist as exchange-traded funds (ETFs) with their names and symbols being: the Rydex S&P 500 Equal Weight Index (RSP), the S&P 500 Depository Receipts (SPY) and the FTSE RAFI US 1000 PowerShares (PRF). RSP, SPY and PRF offer broad exposure to the U.S. equity market in equal weight, cap weight and in fundamentally weighted formats.

Part I also found that PRF exhibits internal defense; therefore, investors can do without defensive rotations to and from the iShares Dow Jones Select Dividend Index (DVY) and the iShares S&P 100 Index (OEF). HQ Defense was the label given to the DVY+OEF allocation because DVY+OEF are sources of high-quality stocks (HQ)1. Historically, HQ has declined less than core equity indexes during recession periods and equity corrections.

Part II expands our focus to sector rotation strategies that execute portfolios with 1.0 or higher beta (offense) and others with less than 1.0 (defense)2.

Part II
• Equity sector rotation & factor betas
• Recent performance
• Satellite portfolio construction
• Climate
• Housing & the credit cycle
• Portfolio A's (a long-short model portfolio)
• Anti-carry and reverse liquidity trades
• Investment thesis & themes

RSP, SPY and PRF are core equity (broad market) holdings. Concentrated positions in small cap, mid cap, large cap, value, growth and/or equity sectors are known as satellite holdings because their source returns are specific to subsets of the broad market related to size, style and/or industry. Core plus satellite portfolios (Core +) source returns from broadly indexed equities plus satellite holdings in domestic and/or foreign markets. Our present satellite focus is on industry sectors and other asset classes, namely bonds, commodities and cash-yield currencies, which are viewed as performance enhancers (portfolio alpha).

Equity Sector Rotation
Equity sectors are sources of alpha primarily for strategic asset allocation managers. They seek timely shifts between low, high and negative beta exposure through varied sector and/or asset class weightings (on a long-only or on a long/short basis). Before executing a strategy, it helps investors to group equity sectors into offense and defense categories.

To sort things out, we quantify three sources of beta. Our methodology quantifies the past relationship of equity sector performance to market, economic and credit trends. Doing so aids in the evaluation of current sector performance relative to historic trends. A quantitative process limits human bias that interferes with the execution of a money manager's investment thesis. A composite beta score for sector exposures also aids managers in their asset allocation and risk management objectives.
Figure 1 displays the Dow Jones (DJ) Sector Legend for the DJ Total Market Index (DJTMI) and its constituent economic sectors. Here we find the DJTMI, DJ sectors and their respective iShares ETFs, offense (high beta) and defense (low beta). Composite betas for offense and defense (top of columns 4 and 5) result from equally weighting the five highest and five lowest beta scores for the 10 DJ sectors.

Offense holds sector ETFs with the five highest betas. They range from 11.2 (ranked #1) to 6.6 (#5). Defense includes the ETFs ranked #6 to #10, which are the least to the most defensive sectors. They range from 4.4 (#6) to 0.2 (#10). Beta rankings result from the sum of each ETF's market beta (A=DJTMI) + economic beta (B=RGNP)3 + credit risk beta (C= sensitivity to interest rate differentials between high- and low-quality debt). Each sector carries a different market, economic and credit beta. These are the most relevant factors for grouping industry sectors into offense and defense. Rankings are dependent on the factors employed and scoring methods (alternatives to A+B+C).

Based on this process, technology is the most offensive sector (ranked #1) while health care is the most defensive sector (#10). The former scores 11.2 while the later 0.2. Sector scores in column 8 are the sum of columns A+B+C. Group averages are 7.7 for Offense and 2.0 for Defense (see top of columns 4 and 5). Offensive ETFs are nearly four times more sensitive to our factors as defensive ETFs and 1.6 times more sensitive than the market (IYY).

Figure 1. Dow Jones Sector Legend
Figure 1

Beta scores are purely driving seven sector weights, these being technology, basic materials and utilities that are underweighted; health care and consumer goods, which are overweighted; and the industrial and consumer service sectors, which are neutral weight. In addition, special valuation considerations are employed in relation to the financial, energy and telecom sectors.

1 Defensive rotations to DVY and OEF occur when the S&P 500's 50-day moving price average (DMA) falls below the S&P's 200 DMA. Rotations result in selling 40% of a core equity position (SPY or RSP) and then allocating the proceeds to DVY and OEF. 60% is invested in DVY and 40% to OEF. This results in allocations of 60% to core equity, 24% to DVY and 16% to OEF (SPY + Defense and SPXEW + Defense).

2 Beta is a statistical metric that measures how sensitive a security, portfolio or asset class is to price movements of a broad market index. Betas less than 1.0 move less while betas greater than 1.0 vary more than a specific index.

3 Real gross national product (RGNP) is a more sensitive measure for evaluating economic sector performance than nominal or real gross domestic product.

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