etf-portfolio-construction4

Foregoing stock selection for sector selection with ETFs, and picking the ones expected to do best, is a way to outperform the competition. But the same conclusion for stock selection applies. Concentrate your portfolio. But this is more difficult with ETFs because most are already broadly diversified.

“Impact of sector picking on returns” shows the contribution to return variance from sector-specific factors and the market for 10 U.S. industry sectors. The weight of each sector in the S&P 500 is shown, progressing from low (Telecom) to high (Information Technology). Utilities (47%), Energy (55%) and Healthcare (62%) have the lowest market impact on returns. Industrials’ returns, on the other hand, are largely explained (89%) by the market.

One active method of ETF portfolio construction is to select sectors that are expected to do well during different phases of an economic cycle. Something predictable happens when sectors are combined—the market’s influence over return variance increases.

We grouped three sectors to address each phase of an economic cycle (see “Impact of sector selection,” below). Consumer Staples, Healthcare and Utilities were used as an example of a defensive cluster. When combined, only 13% of the cluster’s return variance was explained by sectors and 87% by the market.

Other groupings owed even more of their return variance to the market—expansion at 96%, and aggressive at 93%. We assigned different sectors to the economic phases, but any combination leads to a similar market-dominating result.

In practice, a portfolio would likely include a broad-based index in addition to these sectors, making the market’s influence even more pervasive. So how can advisors add value when the market dominates return variance?

  1. Pick the right markets and asset classes. As asset classes become more correlated, this becomes less effective.
  2. Find a reliable method to determine risk-on and risk-off timing. Market timing is difficult but remains the most effective way to actively manage ETF portfolios.
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Table: Impact Of Sector Selection

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Table: Impact Of Sector Pricing On Returns

Originally published in Advisor's Edge Report

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