ETFs & Sector Rotation: Large Cap, Small Cap, Or International?

by on June 6, 2011 | Updated November 21, 2012 | ETFs Mentioned:

Sector rotation techniques have been around for decades, a relatively simple strategy often used by investors seeking to capitalize on short-term mispricings in order to generate alpha. In its most basic form, sector rotation involves segmenting the equity universe by industry, and moving into and out of various sectors depending on relative attractiveness from a valuation perspective. The idea is to overweight the sectors that are attractively priced, and underweight those that are deemed to be overvalued. Those who are able to identify overbought and oversold sectors–or even broader trends that may favor high beta or low beta stocks–can beat the market by regularly shifting exposure [see also Nine Twists On Sector ETF Investing].

More recently, ETFs have become popular tools for investors implementing sector rotation strategies; instead of requiring investors to identify individual stocks with promising outlooks, a high level approach can be employed to achieve broad exposure to a number of industries with a single ticker. And innovation in the ETF industry has allowed for enhanced granularity; sector-specific ETFs no longer include the nine primary industries, but sub-sectors such as medical devices, gaming, fishing, and airlines [see Free Report: How To Pick The Right ETF Every Time].

The suite of sector SPDRs are generally the most popular tools for investors looking to implement a short-term tactical tilt towards or away from a certain sector, and the trading volumes on these funds illustrate the appeal to investors with a limited holding period. The Energy SPDR (XLE), for example, has an average daily volume of 19.5 million shares–about 15% of the total shares outstanding (implying an average holding period of 6.5 days). But thanks to the innovation in the ETF industry, there are now numerous options available for investors looking to achieve targeted exposure to a specific sector of the economy. PowerShares offers a suite of small cap sector ETFs, while iShares has debuted a number of ex-U.S. sector funds. And the evidence suggests that these various versions of sector ETFs offer very unique risk/return profiles [see 50+ All-ETF Model Portfolios].

So investors looking to implement sector rotation strategies have numerous options available to them, including targeting exposure by market capitalization and geography. Picking sectors to overweight or underweight is only the beginning of strategy implementation; sector rotators must then decide which of the numerous tools to use to express their view. And as shown below, that choice can have a major impact on bottom line returns [see For ETF Investors, The Details Matter].

Consumer Discretionary

The following table shows the year-to-date performance of three Consumer Discretionary ETFs through May 2011:

Ticker ETF YTD
XLY Consumer Discretionary Select Sector SPDR 8.45%
PSCD S&P SmallCap Consumer Discretionary Portfolio 6.33%
AXDI MSCI ACWI ex US Consumer Discretionary Sector Index Fund 4.05%

XLY has performed better than its small cap and international counterparts in 2011. While the difference isn’t massive, it is certainly material. AXDI has significant Japan exposure, which may be part of the reason why it is lagging behind its U.S. counterpart.

Consumer Staples

The following table shows the year-to-date performance of three Consumer Staples ETFs through May:

Ticker ETF YTD
XLP Consumer Staples Select Sector SPDR 10.84%
PSCC S&P SmallCap Consumer Staples Portfolio 12.27%
AXSL MSCI ACWI ex US Consumer Staples Sector Index Fund 6.73%

In this corner of the market, small cap exposure has been the way to go so far in 2011; PSCC has outperformed the large cap-heavy XLP by about 150 basis points.

Energy ETFs

Energy ETFs have performed quite well in 2011 thanks to skyrocketing commodity prices and record profits from Big Oil. But it is actually the smaller energy companies that have led the way; the gap between PSCE and XLE is sizable, and the delta between small cap U.S. energy stocks and international counterparts is greater than 10% [Energy ETFs: Six Very Different Ways To Play]:

Ticker ETF YTD
XLE Energy Select Sector SPDR 13.34%
PSCE S&P SmallCap Energy Portfolio 17.17%
AXEN MSCI ACWI ex US Energy Sector Index Fund 6.78%

Financials

The financial sector is another illustration of the significant return differentials caused by nuances in sector ETFs; XLF was in negative territory during the first five months, while the small cap option and international ETF had both gained ground:

Ticker ETF YTD
XLF Financial Select Sector SPDR -0.44%
PSCF S&P SmallCap Financials Portfolio 4.55%
AXFN MSCI ACWI ex US Financials Sector Index Fund 3.39%

Healthcare

The health care sector has surged so far in 2011, but the gains have been anything but even; small caps have beaten large caps in the U.S. by a wide margin:

Ticker ETF YTD
XLV Health Care Select Sector SPDR 15.14%
PSCH S&P SmallCap Health Care Portfolio 21.85%
AXHE MSCI ACWI ex US Health Care Sector Index Fund 15.97%

Industrials

The tables are turned in the industrial sector where XLI, which includes bellwether names like GE and Boeing in its top holdings, has led the way:

Ticker ETF YTD
XLI Industrial Select Sector SPDR 8.37%
PSCI S&P SmallCap Industrials Portfolio 3.06%
AXID MSCI ACWI ex US Industrials Sector Index Fund 7.89%

Materials

The following table shows the year-to-date performance of three Materials ETFs through May:

Ticker ETF YTD
XLB Materials Select Sector SPDR 3.81%
PSCM S&P SmallCap Materials Portfolio 4.58%
AXMT MSCI ACWI ex US Materials Sector Index Fund 0.85%

This is another case that points to a stronger U.S. economy when compared to developed nations around the world, as both domestic funds have beaten out their international challenger by at least 2.5%. Because these ETFs invest in companies in the business of producing raw materials from various commodities, it is surprising to see these funds having a positive 2011 after the first few months saw sky-high commodity prices across the board and a quick tumble back to more moderate levels in May.

Technology

Investors with a bullish outlook on the tech sector have had very different experiences depending on how they chose to achieve exposure; those focusing on U.S. stocks are likely much happier than those who chose an international focus:

Ticker ETF YTD
XLK Technology Select Sector SPDR 5.38%
PSCT S&P SmallCap Information Technology Portfolio 8.78%
AXIT MSCI ACWI ex US Information Technology Sector Index Fund -3.22%

Utilities

The following table shows the year-to-date performance of three Utilities ETFs through May:

Ticker ETF YTD
XLU Utilities Select Sector SPDR 9.10%
PSCU S&P SmallCap Utilities Portfolio 8.49%
AXUT MSCI ACWI ex US Utilities Sector Index Fund -0.33%

While both U.S. utilities products were relatively close in performance, the international ETF is a clear laggard, steering investors clear of global utilities altogether.

Verdict

There is, of course, no universally superior means of implementing a sector rotation strategy. In certain environments small cap stocks may make for a better investment experience, while others may favor large cap stocks. As the tables above illustrate, the different options available may seem generally similar–but in reality offer very unique risk/return profiles. Impressive innovation in the last several years has given ETF investors more options than ever before. The hard part is figuring our just which tools to use to maximize results.

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Disclosure: Photo courtesy of Andrew Dunn. No positions at time of writing.