How To Pick A Sector ETF

Sector investing is popular, and we’ve been hearing a lot about sector rotation opportunities in the face of changing correlations since President Trump’s victory last year. But as an investor, how do you know when it’s time to get in or out of a sector? How do you pick the best sector to be in?

Unfortunately, there’s no single recipe that works here. Different investors look at different metrics and go about it in different ways in their hunt for the best sector for maximum return and minimum risk—price momentum, historical relative performance, job market trends, changes in volatility, volume, GDP data, etc.

We asked four ETF strategists for a little help, with a three-part question that asked the following:

• What's your top sector pick right now?
• What signals do you look for to decide when it's time to jump in or out of a sector?
• What ETFs do you recommend to access your top sector pick?

Here’s what they had to say:

Rob Stein, CEO, Astor Investment Management, Chicago

Our top sector now is financials. We are getting our exposure using the Financial Select Sector SPDR Fund (XLF).

At Astor, we are fundamentally and economically driven. For sector allocation, we look to see how much a sector is contributing to overall economic growth. We compare that to historical trends of a sector’s contribution, and we then overlay a momentum indicator for confirmation.

We have a proprietary indicator of the economy, the Astor Economic Index, which gives us a “live read” or “now-cast” of the economy. We adjust equity exposure based on the index. Keep in mind that a neutral reading correlates with a positive expected return for stocks.

We then drill down into sectors to see which ones are contributing the most to economic activity, analyzing things like GDP and employment trends. Lastly, we confirm this with our proprietary trend indicator and risk indicator.

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.

Andrew Gogerty, vice president, investment strategies, Newfound Research, Chicago

At Newfound, on the quantitative side, we find there is a lot of evidence for systematically applied value-, momentum-, or trend-following-based approaches to sector investing.

For those sectors identified as exhibiting positive trends, we seek to exploit diversification by equally weighting their exposure in the portfolio.

On the behavioral side, instead of focusing on upside alpha opportunities, Newfound’s sector-based portfolios instead focus on trying to avoid significant downside losses. There, we employ a proprietary trend-following model to remove sectors from the portfolio that are exhibiting significant risk of loss.

In other words, our focus is not on those sectors we expect to relatively outperform, but on those sectors we believe could lead to the absolute loss of capital.

Today our models indicate positive trends across all of the primary U.S. sectors. Under the hood, however, we can see that our models are least confident about the trends seen in the energy, staples and utilities sectors. If we continue to see further sustained negative price movement in those sectors, that would eventually lead to the removal of those sectors from our portfolios.

Michael Venuto, co-founder and chief investment officer, Toroso Investments, New York

In our Sector Opportunity Portfolio, we look at job creation per sector and industry on a three-, six- and 12-month basis. Last September, in the report from the Department of Labor, we saw an increase in financial jobs, specifically in the banking industry. In October, we established a position in the SPDR S&P Bank ETF (KBE), which, pre-election, was quite scary.

We follow the fundamentals of job growth, and banking—within financials—continues to grow. Other sectors we currently like are technology, industrials, health care services and materials.

Contact Cinthia Murphy at [email protected]