ETF Sector Rotation Strategies: Beyond the SPDRs

ETFs may have originally been designed for investors interested in implementing long-term, buy-and-hold strategies, but the numerous advantages of the exchange traded structure, such as intraday liquidity and enhanced transparency, have attracted all types–including a much more active crowd. It’s no secret that ETFs have become popular among traders that measure holding periods not in years, but in hours and minutes. Many of the new products that have debuted in recent years have been explicitly designed for these sophisticated traders operating within a short time frame.

Joining the buy-and-holders and high-turnover day traders are those that fall somewhere in between: investors who make tactical tilts towards, or away from, various asset classes depending on current market prices and their outlook for the global economy. ETFs have become popular tools for implementing sector rotation strategies, techniques that essentially overweight or underweight various segments of the stock market depending on the risk and return of each.

The most common ETFs for investors looking to target a specific corner of the equity market are the Sector SPDRs, a suite of funds that debuted more than a decade ago and essentially segments the large cap U.S. equity market into nine groupings: financials (XLF), energy (XLE) and so on. These products have some obvious advantages; most notably, they are very cheap and very liquid. And while they may have been among the earliest sector-specific offerings, they are no longer the only game in town.

There are now other options available to investors that utilize different strategies, which may fit better with certain styles of investing. As many issuers have proven, market-cap weighting or large cap holdings are not always the way to go. For investors interested in a sector rotation strategy, the impressive innovation in the ETF industry over the last several years has resulted in a number of different options. Below, we outline various options to give investors a fresh take on the sector investing ETFs that are currently available:

Equal Weight ETFs
Ticker	Sector
RYE	Energy
RYT	Technology
RYH	Health Care
RTM	Materials
RGI	Industrials
RYU	Utilities
RCD	Consumer Discretionary
RHS	Consumer Staples
RYF	Financials

Equal Weight

Almost all funds available today, passive or active, weight their holdings by market cap, giving the big names like Exxon Mobil (XOM) heavy allocations while giving lesser known companies smaller weights. But recently, issuers have begun to poke holes in this methodology, as overvalued stocks tend to be overweighted and vice versa. Cap weighting can also result in top heavy funds like XLE, who’s top ten holdings account for more than 63% of the product. This leads to a skewed allocation, as a small number of companies dominate the performance of the ETF as a whole.

Equal weighting takes every stock and simply gives them an equal allocation regardless of market cap, resulting in a more balanced portfolio. And when it comes to the equal weight S&P 500 ETF, RSP, it has outperformed its big-league competitor SPY by a substantial amount. Looking to Rydex’s line of equal weight products, nearly half of the equal weight products have outperformed their SPDR counterparts in 2011.

Investors looking for alternatives to the nine SPDRs should consider these funds, as their diversity and performance make them some of the most enticing choices in the ETF space.

Small Cap

While large caps represent a stable investment, they have their fair share of issues. Large caps can often miss out on the trends and growth of an individual economy as these giant firms are typically multinational companies with global operations. Small caps, on the other hand, come with their share of added risk, but get investors closer to the ground and allow them to make more of a “pure play” on a sector or market. Small caps also maintain a greater growth potential as these companies have yet to hit their peak growth, and have the potential to become one of the next biggest firms in their respective market. Because the SPDRs are almost entirely large cap, they miss out on key exposure in each respective sector.

While the large cap SPDRs slice and dice the S&P 500, a suite of nine funds from PowerShares segments the S&P SmallCap 600, giving investors the opportunity to make a small cap play on their favorite segment on the U.S. economy. The list is as follows:

• S&P SmallCap Consumer Discretionary Portfolio (PSCD)
• S&P SmallCap Consumer Staples Portfolio (PSCC)
• S&P SmallCap Energy Portfolio (PSCE)
• S&P SmallCap Financials Portfolio (PSCF)
• S&P SmallCap Health Care Portfolio (PSCH)
• S&P SmallCap Industrials Portfolio (PSCI)
• S&P SmallCap Information Technology Portfolio (PSCT)
• S&P SmallCap Materials Portfolio (PSCM)
• S&P SmallCap Utilities Portfolio (PSCU)

AlphaDEX

First Trust maintains a stable of products linked to enhanced AlphaDEX benchmarks–indexes that use quant-based methodologies to select component companies with the most promising return potential. The objective here is to generate alpha relative to funds such as the sector SPDRs, but this quant strategy comes with a drawback; it is considerably more expensive than its more traditional counterparts [see also ETFdb Category Kings: Best Performers From First Half Of 2011].

Where XLF charges fees of just 0.20%, the Financials AlphaDEX ETF (FXO) charges expenses of 0.70%. Some investors may find this difference in expenses to be of little concern given that FXO is outperforming XLF on the year by more than 400 basis points. In fact, investors will find that AlphaDEX products have out performed several of the SPDRs, which may make these expenses worth it in the long run.

Ex-U.S.

Recent years have developed the trend of investors avoiding investments in the U.S., as many feel there is little growth potential left in our home country. For investors looking to avoid the U.S. entirely, iShares offers a suite of sector-specific ETFs that segment the international economy, featuring countries like the U.K., Germany, Switzerland, and many others. The line features ten products, with the extra sector coming from an information technology fund, a unique investment that the traditional SPDRs neglect.

Emerging Markets

Emerging markets have become increasingly popular over the past few years, as investors seek to find high growth opportunities that developed nations simply cannot offer. While these products are inherently risky, their potential returns are enormous, and they certainly have a place in every investment portfolio. EG Shares has a line of sector-specific products that grant exposure to popular emerging markets like China, Brazil, India, and many others [see also Seven Factors Every Investor Needs To Know About Emerging Market ETF Investing].

• Financials GEMS ETF (FGEM)
• Consumer Goods GEMS ETF (GGEM)
• Health Care GEMS ETF (HGEM)
• Industrials GEMS ETF (IGEM)
• Basic Materials GEMS ETF (LGEM)
• Energy GEMS ETF (OGEM)
• Technology GEMS ETF (QGEM)
• Telecommunications GEMS ETF (TGEM)
• Utilities GEMS ETF (UGEM)
• Consumer Services GEMS ETF (VGEM)

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

Original post