Sector-based exchange-traded funds (ETF) can play an important role in investment strategy. They help diversify risk by spreading investment funds across the equity stocks of more than one company or even more than one country.

But they have an additional key characteristic. They can turn a passive approach to investment into something very different: tactical industry-based positioning. Investors who want to do more than slavishly follow an index can use ETF to tilt their portfolio.

Says Nizam Hamid, ETF strategist in Europe at ETF specialist WisdomTree: “You might have a view on financial institutions and think banks are very cheap by traditional measures. An ETF can spread risk through diversification while tilting your portfolio.”

Nizam Hamid, ETF strategist in Europe, WisdomTree

Passive into active

In effect, choosing a sector-based ETF turns a supposedly passive investment into an active investment. Merryn Somerset Webb summed it up in a Financial Times column on 24 June about MSCI’s decision to include China mainland stocks in its emerging market index.

“If you choose an MSCI index to follow, you should remember creating that index involves regular stock picking and regular asset allocation decisions. Index investing does not make you a passive investor...it just means you have chosen MSCI to be your active manager.”

State Street Global Advisors is an ETF pioneer and giant. It says in its SPDR (pronounced spider) ETF explanation that a sector approach enables investors to take advantage of economic trends that have targeted implications for the performance of specific industries.

Nuanced investing

State Street says that adding a sector strategy to a portfolio allows for nuanced investing without introducing the potential for additional idiosyncratic risk through single-stock investing. Sectors can out- or underperform during different phases of the economic cycle.

This behaviour is driven by factors such as corporate earnings, interest rates, and inflation. Investors can use ETF to increase their allocation to sectors expected to outperform because of cyclical trends.

They can also cut their allocation to sectors that are expected to underperform. Interest-rate-sensitive sectors like consumer discretionary, technology and financials tend to benefit in the early stages of economic recovery, as more confident consumers increase borrowing.

People buy when interest rates are low

People tend to buy things like cars and houses while interest rates remain low. But these sectors tend to perform less well when the economy contracts, as interest rates rise and consumers’ borrowing ability decreases.

As sustained growth in the economy matures and slows, materials and industrials will generally experience gains as their sales increases. When the economic cycle moves into recession, inflationary pressures can lead to outperformance in the energy sector.

Businesses with stable revenues, like healthcare, consumer staples and utilities, tend to perform well. Investing in entire sectors helps reduce the risk that a collapse in a single stock has a large adverse impact on the entire portfolio.

Diversification inherently good

It is inherently good to have diversification and to reduce risk, says Nizam Hamid. An ETF will help investors do that. “But you might want to take a slightly different approach and buy exposure with a bias to value stocks or high-yield: so-called smart beta strageties.”

From his extremely specialist niche in the financial world, he has developed the view that investors have a tendency focus too much on return and not enough on the risk associated with any individual investment.

“Owning equities is great for some investors, but a more defensively minded approach might suit others better,” he comments. He then adds that it is essential to understand the ‘portfolio effect’, holding different assets that are not highly correlated with one another.

Multi-asset portfolio will contain

• Developed market equities
• Emerging market equities
• Small cap companies
• Government bonds
• Corporate bonds
• Commodities

“In a multi-asset portfolio you want uncorrelated assets to lower the total risk of the portfolio, including developed market equities, emerging market equities, small cap companies, government bonds, corporate bonds and commodities,” he adds.

The key goal ETF sector investors are pursuing is diversification between sectors, states the comprehensive guide published by etfgi.com in 2015 and still a good read. “They want to see categories as distinct as possible, with performance as widely different as possible.”

“Otherwise, why bother to separate them in the first place?” it asks. From that standpoint, the effect of these differences is espe­cially well illustrated during periods of high volatility, the guide goes on to say.

Banks could be attractive

Nizam Hamid returns to the example of banks as a sector that ETF could enable investors to buy into without assuming undue risk. He argues that banks are cheap in terms of book value because of the issues of non-perfoming loans and ultra-loose monetary policy.

Banks cannot generate profits in a low interest rate environment, he observes, but quantitative easing is coming to an end and interest rates are beginning to rise. All other things being equal, higher rates benefit banks and this should enable a return to profit.

As anyone who has studied the banking world for decades will know, once banks stop making provisions, and begin making new profits, they can very quickly become money-making machines.

Bank equity a tactical buy

The 2017 first quarter investment strategy presentation by Lyxor, which has been running ETF since 2001, longer than any other currently European provider, paints bank equity as a tactical buy.

The sector mirrors the deflation/inflation rollercoaster, it notes. And while structural hurdles remain in place, in particular with regard to regulation and non-performing loans, the worst is behind the sector, observes Lyxor, and recapitalisations are under way.

In this context, the return of Allied Irish Banks to market this week is a picture that paints a thousand words. The collapse of the bank helped push Ireland to an international bailout, the Financial Times reminded readers.

AIB demonstrates bank resilience

The Irish government raised at least €3bn in an initial public offering which valued the group at €12bn. The FT adds that the offering was priced at €4.40 per share, in the middle of the previously announced price range and in line with analyst expectations.

Other sectors identified by Nizad Hamid as highly accessible via the ETF route include more defensive areas such as healthcare and utilities, as cited by State Street Global Advisors, as well as the oil industry and consumer stocks, utilities and industrials.

Sector-based ETF enable investors to play a macroeconomic theme, he says, returning to and developing further his earlier argument, while going overweight in low-volatility sectors can reduce risk in the overall portfolio.

Attractive sectors include

• Healthcare
• Utilities
• Consumer stocks
• Oil industry
• industrials

While WisdomTree does not itself offer sector-based ETFs as part of its product range, it does view sectors from a macroeconomic perspective. This positions it well to address the subject without being accused of talking up its own book, notes Nizam Hamid.

Wisdom Tree's smart beta brochure tells how ETFs had nearly $52bn in inflows in 2016, as measured by Morningstar. This represented 14% growth in assets under management for the European ETF industry.

By the end of November 2016, ETF assets under management increased to nearly 18% of mutual funds globally, while in 2000, this ratio was under 2%. There are more than 2,230 ETFs/ETPs with more than 7,000 listings, from 57 providers across 25 exchanges in Europe.

ETF benefits

• Low cost
• Tax efficient
• Convenience of exchange trading

Many of the advantages ETFs have over traditional mutual funds derive from the similarities they share, inter alia, with equities in terms of liquidity and flexibility.

In short, though, there really is a short explanation for the allure of ETF as part of the determined investor’s toolkit. “They allow you to manage your portfolio better,” concludes Nizam Hamid.