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.
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.