Specialization Evolves

Late in August I will be speaking about ETFs at an event called the Money Show in San Francisco. In addition to the two panels I am on I am writing an article for some sort of publication connected to the event (candidly I do not know the details of this). The article was requested to be 2500-3500 words which is much longer than anything I have ever written.

The article will focus on portfolio construction at the sector level using ETF. I have explored this sort of thing before but as more products come out the chance to create a mix that could only be done previously with individual stocks is starting to become reality. Except for Norway.

Basically I constructed a sample portfolio going sector by sector and the article consists of the rationale for each of the sector allocations. While I am not going to front run that article I can pick a sector and build it with different funds and still make the same point. A few days ago I touched on the industrial sector in a similar context to I'll stick with that one here.

The industrial sector currently has a 10% weight in the S&P 500. Usually it makes sense to underweight the sector when the cycle gets long in tooth and then overweight it after a big decline. You can decide for yourself whether overweighting or underweighting is the better position right now. However when you think it is time to underweight the sector you probably also would want to reduce the volatility of the holdings you are using to make up the sector. The process of transitioning to overweight from underweight would probably coincide with increasing the volatility of your exposure.

Consider the follow four ETFs that fall under the industrial sector (either entirely or mostly). For space sake I'll just use the symbols, you can look them up if you care and BTW I don't own any of these personally or for clients which speaks to the choice available.

XLI--megacap domestic exposure relatively low volatility
TAN--solar themed fund that is a wild ride in both directions
FLM--engineering companies that will design and build the world's infrastructure
PTRP--anything involved with greener transportation; volatility is between XLI and TAN

In hindsight it would have been better to have been underweight the sector, owning only XLI and then on March 9 sold out of XLI and gone to an overweight position using some combo of the specialized funds all of which have performed better than XLI off of that low. I would note that all four funds outperformed SPY off of the March low which should not be a shock based on the above comments about when to overweight the sector.

That last paragraph might seem silly but it isn't from the standpoint of the narrower themed funds lagging (even if just slightly) on the way down most of the time and leading on the way up and the sector (as measured by XLI) trailing behind SPY on the way down and outperforming on the way up. Being correct about when the market is going up or down is obviously the key variable and very difficult to get right so being 100% in XLI or 100% in a bunch of more volatile specialized funds is never the solution unless you are very aggressive.

While knowing what the market will do is elusive it is comforting to know that certain things, like the above, will stand up the vast majority of the time. If you believe in active management (even if you are your own manager) then at some point a decision needs to be made. Getting the timing right is not easy but knowing how to increase or decrease your volatility is easy. In a hyperbolic example you know that switching your industrial exposure from GE to First Solar is going to change the behavior of your portfolio a lot. It would be the same switching your industrial exposure from XLI to TAN. Changing the combo of the same four ETFs a little less dramatically would make the effect on the portfolio much less severe.