Sector ETF Investing: Black Diamond, Beware

Jul 30, 2012


At ski resorts in the U.S. each ski run is denoted with a symbol.  A green circle is for 'Easiest' runs, a Blue Square is for 'Moderate' and the more difficult runs are marked with a 'Black Diamond'.  A Double black diamond would be for experts only.   Perhaps ETFs should adopt this system?  


The most volatile are black diamonds and any short-duration bond funds would be marked Green.   Of course, there is no enjoyment in going 'down' green runs, you spend all your time and effort just planning how you are going to maintain some speed so that you don't come to a complete stop. 


If you look at virtually any institutional money managers quarterly or semi-annual review,  there is usually something that has a few lines similar to this:  'we are overweight energy for reason X [and insert reason why] and underweight financials for reason Y [and insert reason why]' etc...   Then there is usually a data table comparing the fund to its benchmark across each sector.


Let's take a look at some recent trends in Sector ETF investing.  For this, we pair up 2 sectors:  [Financials + Energy] vs [Staples + Utilities].    We link these together because these are classic 'High-Beta' vs 'Low-Vol' types of analysis (in recent years the popular terminology has been: 'risk-on' / 'risk-off') -- but it's all the same idea.   


Below is the second half of 2011.  


Put yourself in the spot of a fund manager trying to explain their sector positioning at each point in time.   Note that Staples + Utilities had a sharp but very short-lived corrective move beginning in July, 2011 and then promptly retraced the entire amount back up in September and then actually went back above the July/Aug highs soon thereafter.  Meanwhile, Financials and Energy continued to correct hard into very beginning of October and then go into a vertical short-squeeze type of move up that lasts about a month and then entering a volatile trading range through the end of the year.

By the time the year ends, many managers not watching such things in this format are wondering how in the world the S&P 500 ended up +2.0% (total return) for the year.    Hedge funds got whipped around badly as this action is indeed very tricky if you are spending your time trying to figure out how it all makes sense fundamentally.  But the fact is that the market doesn't sit around and wait for you to figure out how it all makes sense before it does its next thing.    Managers coming up with reasons for their quarterly positioning often have a tough go of figuring out how to make it look like they know what they are talking about.

Ok, so now say you got it right during the second half of 2011 and were overweight low-vol segments (think high dividend stocks).  Great.  Now the first quarter of 2012 begins and the exact opposite occurs.


As the new year got underway, the market begins with a large rally in 'high-beta' assets while classic low-vol sectors like Staples & Utilities actually go down.   High-beta had a big first quarter with low-vol lagging.   The manager who was (rightly) defensive in 2011 now has a tough time justifying why they are off to such a rough start to 2012.   Some managers likely then took their high-beta exposure up to reduce the pain.     And what has happened since then?  


Naturally, there was another large internal rotation with the overall market going nowhere while low-vol segments outperforming strongly with high-beta trading down.

So that is where we stand now --- these sets of ETFs are now essentially up about the same amount YTD -- but with very different paths to get here.    Given the large outperformance during the second half of 2011, the 12-month chart of course looks quite different --- with low-vol segments like Staples and Utilities back at all-time highs.

A lot of members who begin at ETFreplay set up a 'sector portfolio' --- ie, the Sector SPDRs or Vanguard Sectors.  It might be natural -- that is how a lot of people think about investing -- overweight this sector and underweight that sector.     But once you start backtesting such strategies, you may start to realize --- wow, this doesn't work very well.  

Well, look on the bright side, it's a good thing you tested it before thinking you had something.   Indeed, sector investing can be treacherous and that isn't a new thing.   We have done many examples on this blog and within the demos on the site and we've never done a sector example (it wasn't for a lack of trying various ideas).  The reason is that we just think there is a lot of lower hanging fruit than that.   We don't care to ski double black-diamonds when there are nice blue square runs out there.  

That all said, if you do indeed want to test sector strategies -- then we suggest a particular module called  'Ratio Moving Average backtest' -- our work shows some potential in this area.   However, we would stay away from things like XLE vs SPY.  There are 1400 ETFs after all, it's ok to have some imagination beyond the over-researched and over-analyzed sector approach.

Thinking from a return-risk perspective,  we do have one idea for sectors -- it involves just buying and holding lower-vol sectors and then barbelling that by tactically adjusting higher-beta exposures using the 'Ratio Moving Average' module.   If you do it like that, then you will generally create risk in the end that is similar to the overall market -- and you will greatly reduce getting caught in buying back into high-beta AFTER its had a run.

The 'Ratio MA' module compares 2 ETFs and attaches rules to trade the ratio between two market segments.   We prefer using uncorrelated ETFs in this analysis --- ie,  XLF vs IEF  --- rather than one equity ETF vs another equity ETF.  But we certainly look forward to seeing other possible techniques by watching members ideas develop on the Allocations Board

Summary:  In our opinion, sector ETF timing is something that we think is probably over-researched (and the charts above indicate its 'black-diamond' nature).

Backtesting is inherently evidence-based.   When you learn something in backtesting, then use that knowledge.   Don't try to force-fit a generic sector list into a strategy --  be flexible and don't stop the learning process.  Financial relationships can be dynamic --- that is, they can change in sometimes tricky ways.   If you have trouble making something deliver good reward/risk -- then take heed -- it probably has no edge and is therefore just a random walk.  Like the signs in the picture above --- there are various levels of difficulty.   If you go down the steepest run,  you may 'expect' to get to your destination more quickly -- but that doesn't mean you actually will -- the chance of crashing and burning is the other possible outcome.   The last 20 years are filled with managers who ski'd recklessly and won the short-term race  --- and then eventually ended up in the Ski Patrol sled.

Focus on reward-risk as a relationship.   Not just return and not just risk.



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Comments (3) -

Jul 31, 2012 18:27 #

Interested to know how you do incorporate sector etf's if any into your strategies and also a couple of examples of what you are referring to as low hanging fruit.

conyer United States

Aug 01, 2012 09:14 #

There are very likely 'institutional issues' with sectors given that so many managers discuss their portfolio this way.     When financials tanked during the second half of 2011, it became very popular to say you owned very few financials at year-end.   Then financials went vertical up during Q1.     Then one of largest banks in world (JP Morgan) had trouble and the bank sector reversed back down.   So while JPM is up this year --- if you bought in March or April -- you have taken a performance hit.

If you use market cap based ETFs and are focused more on bigger themes -- like stocks vs bonds etc, then you aren't really so exposed to internal gyrations like in the charts above.    Market cap segments will have exposure to all sectors at all times.


The point of the blog was to just discuss the fact that sector based lists using typical default settings have backtested poorly.   That isn't new,  no matter when you began testing it.

Of course, since 'low-vol' has been in favor --- then ramping up the % to low-vol can explain sector performance in terms of a backtest on the last few years.

So here is a path to test --- start with low vol as a core portfolio (just rebalance it, you don't trade in and out) --- and then layer on tactical strategies on top of that.   That way, the low-vol nature gives you room to get more aggressive elsewhere in your portfolio and still hold overall portfolio to a reasonable level.    You want to control that volatility so that you don't suffer significant capital losses on short-intermediate basis.     Importantly, if & when low volatility stops doing so well on a relative basis, then you have the other part of your portfolio that hopefully does well.

Hope that helps.

Chris United States

Aug 01, 2012 16:19 #

Great explanation Chris...thanks for the ideas!

conyer United States

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