Sector ETF Investing: Black Diamond, Beware

Jul 30, 2012 in Sectors


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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Allocation Example Making 'New Equity High'

Jul 16, 2012

It's still less than 7 months old but this allocation demonstrates what has been working lately.    This 'new equity high' has been driven by REITs, preferred stocks and EM Bond positions.   It's not clear what the benchmark should be on this one --- it's beating 60-40 but it actually holds 'liquid alternative' ETFs -- not equities.     Benchmarks are less important than making new all-time equity highs and generating return at reasonable risk.



New equity high has been driven by some very solid performances in areas like REITs and E.M. Bonds:


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YTD 2012 Update: Generic Stock-Bond Index Fund vs Hedge Fund Index

Jul 03, 2012 in Hedge Funds

We updated this chart for YTD 2012 Performance:

Link to the 2011 Chart as well as the 7-Year Chart Ended March


2 Other Generic 'Endowment-Style' Allocations For Reference  (note: including the above stock-bond chart, all of these YTD returns are clustered in the +5 to +7% range)



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