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Sector ETFs: Jury's out on latest tactical allocation tool

Sector ETFs: Jury's out on latest tactical allocation tool

Fund providers are competing to offer the cheapest US sector ETFs to European investors, but in a roaring bull market, investors are split as to whether they should simply opt for a broad market index.

Sector ETFs focus on one segment of the market, typically carving out stocks from an index like the S&P 500, and can invest in as diverging industries from information technology to consumer staples.

Db X-trackers is the latest provider to bring more of these funds to market, launching six ETFs at 0.12% annual fees, beating iShares’ and SPDR’s US sector ETFs at 0.15% and Source’s at 0.30%.

Michael Mohr, Deutsche Asset Management’s head of ETF product development, said in a statement: “As ETFs are increasingly being used as tactical asset allocation tools, there is demand from investors for granular exposure on a sector basis.”

Flowing in 

There is clearly asset-raising potential in these funds as the iShares US sector ETF range is now more than £1.3 billion in assets having only launched most of the funds in 2015.

Luis Rivera, chief executive of robo adviser ETFmatic, said he preferred to stick to the broad index within portfolios as a cheap S&P 500 ETF was still almost third of the price compared to the cheapest sector ETF.

But Mark Eshman, co-founder of ClearRock Capital, one of the first ETF-focused registered investment advisory firms to set up shop in the US and who is looking at expanding in the UK, said he had been invested in sector ETFs since he founded his firm in 2007.

Beyond core vs satellite

'I think they’re a great complement to a core satellite-type portfolio structure and a great way to demonstrate value,' he said. 'If you can convince your client that you have an outlook on the economy i.e. there’s going to be an expansion or a slowdown, and certain sectors will do better during certain parts of that economic business cycle, then you can create some value.

'For example, emphasising financials when interest rates are rising or energy stocks when we’re in an inflationary period.'

Research from Db X-trackers shows that while cyclical sectors like tech perform well in risk-on environments, defensive sectors like utilities do better in risk-off periods.

Sector performance 

Looking at the MSCI world index, health care was the top performing sector in 2015 at 7% returns, while energy bottomed the charts at -23%. The next year, it had reversed. Energy was up 27% and health care was minus 7%.

Apart from consumer discretionary, consumer staples stocks and telecoms, which saw smaller differences in performance between 2015 and 2016, the divergence of each sector was at least 6%.

The divergences also apply in the US sectors. If investors had taken a bet on the broad market via the Vanguard S&P 500 UCITS ETF (VUSD) they would have received 17.9% in USD terms over the past year to 28 September.

However, investor returns would have increased by more than 10% if they had opted for the less diversified iShares S&P 500 Information Technology Sector UCITS ETF (IUIT) over that timeframe.

In a bull market, which the US has enjoyed since 2009, many sectors have been a relatively safe bet. But entering the next bear market will raise questions of market timing, and how investors should know when to move out of one sector and into another.

When to rotate?

'Sector rotation is difficult as it becomes market timing,' warned Eshman. “But if you have a core holding like a S&P50 ETF and you sprinkle in smaller sector positions, we are all for that'.

But Rivera disagreed, arguing investors end up 'chasing past returns by buying the flavour of the month'.

'Allocating to a sector is by its very nature taking an active bet – forecasting which sector will outperform – as opposed to allocating to the broad market,' he said.

'In many ways, sector ETFs represent the same philosophy as market timing, which evidence leads us to conclude doesn't work in the long-term.'

 

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