Using Sectorology In Portfolio Construction
By Roger Nusbaum, AdvisorShares ETF Strategist
It has been a while since we looked at portfolio construction just using ETFs or mostly ETFs anyway. This is actually one of my favorite forms of ETF analysis, blending together different funds to achieve build a portfolio that hopefully delivers proper diversification and a useful risk adjusted result. I’ll be talking about this topic on Thursday with Mark Yusko from Morgan Creek Capital on the AdvisorShares AlphaCall.
The context here is using more narrow based funds which is closer to my portfolio management background which combines narrow ETFs and individual stocks.
There is still a lot of work to do in assembling all-ETF portfolios. Without carefully looking through to a fund’s holdings it would be easy to end up unintentionally overweight or underweight a sector, an industry, an individual stock even a risk factor like interest rate sensitivity.
I read an article the other day about using single country ETFs to build a portfolio. I am a big believer using country funds but many of them do not track broad based indexes or more correctly these foreign markets’ benchmark indexes are not necessarily broad based. One great example of this is Singapore. The MSCI Singapore Index has more than 35% in financials and another 20% in real estate stocks. Not long ago financials and real estate were the same sector. No matter how you look at buying a Singapore ETF exposes you to a lot of financial sector exposure. That doesn’t have to be a negative but you should probably understand the position you’re taking at the sector level, take a little time to understand the backdrop in Singapore for financial companies and take the time understand the business for any particularly large holdings. One Singapore ETF I looked at (using specific symbols is tricky for compliance reasons) and three different banks each with low double-digit weightings.
Another example of lopsided weighting is Denmark, the MSCI index tracking that country has almost 40% in healthcare. It would be pretty difficult for an ETF tracking Denmark to do much with healthcare going along for the ride. Yet another example would be Taiwan with almost 60%in tech.
I put portfolios together at the sector level. Being overweight or underweight sectors can be a huge driver of returns even if the decision merely revolves around figuring out what to avoid.
Financials right now comprise about 14% of the S&P 500. If the SPX is your benchmark index then investing at the sector level means making a decision about being overweight/underweight/equal weight the sector. If for example you decide to be underweight and you want a 10% weighting in financials you would need to look through to the weightings of these country funds. If Singapore has 35% in financials and Sweden also has 35% (pretty close) to financials and you put 10% in each then symbol math has the portfolio at 7% financials from those two country exposures. While there is software of course that will do this math for you I would encourage some manual spreadsheet work which I think would enhance understanding of the exposures and hopefully encourage some analysis of any large individual stocks (Denmark has 23% in one stock).
A different type of example involves looking around to avoid exposure to an individual stock. Many years ago I wanted to add industrial sector exposure via an ETF but most of the sector funds had 20% or more in a large conglomerate that has since spun a bunch of business off to become much smaller. Back then this company had a huge financial component to its business and I did not want that exposure. I was able to find an equal weight sector fund which obviously had a much smaller weighting in the conglomerate. A decision like that will either be right or wrong but is an easy, active decision to execute where mega caps are concerned.
Although there is a lot more we could go over here, I’ll pick one more example where a niche fund can often be a proxy for a sector. Long time readers might remember I am a big believer in the water theme. There are a few ETFs in the space and they tend to be very heavy in either utilities or industrials. Some sort of narrow based, theme ETF that is 70 or 80% in one sector is a proxy for that sector. If there was an ETF that was just comprised of publicly traded stock exchanges (which I still think would be a good idea) it would be a proxy for financials.
Misusing narrow based funds will lead to client/investor confusion and disappointment which is unnecessary save for just a little bit of work.