Day Hagan Research Update

DAY HAGAN RESEARCH UPDATE

LOW VOLATILITY SECTOR ALLOCATION

What's In My ETF?

SUMMARY

Knowing what you own may help you sleep at night. Sector and stock exposure can change without notice.

WRITTEN BY

Neil Leeson

POSTED

May 20, 2016

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ETF investors should always understand some basic metrics in regard to how an ETF/index is constructed and how it can change. Before investing consider the following:

  • Weighting methodology
  • Rebalancing frequency
  • Fees and expenses
  • Underlying liquidity

Today I want to look at how rebalancing can affect the underlying sector allocation of a fund. I will also follow up on some considerations when holding international funds.

DOMESTIC FUND REBALANCING

There have been several articles written about low volatility ETFs lately. Some articles address the amount of money that has flooded into these names, generating a “crowded trade” call. Others equate low volatility with low beta or low momentum, which isn’t really correct. Nonetheless, rebalancing, the act of realigning the weightings of one's portfolio of assets, can help or hurt. There is no set standard for rebalancing periods. I have tested for optimal periods in the past and have found very inconsistent results. For very long-term investors, rebalancing once a year or every other may be suitable.

In general, ETF rebalancing times have shortened through the years. When the first ETFs came out, they rebalanced in accordance with the underlying index, typically once a year. Currently, many “specialty” indexes and ETFs rebalance on a monthly basis. They do so because the underlying indexes are constructed based on fundamental or technical type screens.

For example, SPLV, the PowerShares S&P 500 Low Volatility Portfolio, invests in the one hundred stocks from the S&P 500 index that have the lowest realized volatility over the past twelve months and rebalances on a quarterly basis. USMV is another popular low volatility fund from iShares that selects low volatility stocks from a larger universe and rebalances on a yearly basis.

Below is the current sector allocation of the two domestic low volatility funds. As shown, there are some significant differences between the two. The Industrials sector, for example, is nearly 17percent of SPLV’s allocation, whereas that sector is less than 5 percent in USMV.


Crrent sector allocation of the two domestic low volatility funds. As shown, there are some significant differences between the two. The Industrials sector, for example, is nearly 17 percent of SPLV’s allocation, whereas that sector is less than 5 percent in USMV.

This is a good illustration of why it is important to know what the underlying exposure is in ETFs, especially if you have several funds in your portfolio. If not, you may have more/less exposure to specific sectors than you may want.

Now let’s back up a year and look at the sector allocation in these two ETFs at the end of April 2015.


This table shows the dramatic change in sector allocation in SPLV from a year ago.

First look at the dramatic change in sector allocation in SPLV from a year ago. The Financials sector was 36.4 percent weight in SPLV. Today that weighting is 20.3 percent, a 1,610 basis-point difference! Financials sector exposure in USMV also declined, but not as dramatically (470 basis points) as it did in SPLV. In addition to monitoring sector changes and how they may affect your portfolio, we can also use the underlying allocation to assess areas that have become more or less volatile. In general, USMV’s annual rebalancing will reduce the underlying fluctuation in sector allocation.

Below is a table showing the current sector allocation in SPLV along with the allocation three and six months ago. This table illustrates some very dramatic changes to sector exposure. Look at the shift in allocation to the Utilities sector. Six months ago the twelve-month realized volatility in Utilities must have been extremely high, since only 4.4 percent of the fund was allocated to this sector. However, based on the latest quarter’s assessment, Utilities have become a lower volatility sector, hence the current allocation of 13.8 percent. So if you have held this fund for the past six months, the fund you bought then is not the same fund today.


Table showing the current sector allocation in SPLV along with the allocation three and six months ago. This table illustrates some very dramatic changes to sector exposure.

Why is sector allocation so important? Because several studies have shown the sector impact on stock returns, and one leading research group found that over 65 percent of an individual stock’s return can be attributed to the “sector effect.”

Anyone that has watched the market over the past several months might think that this percentage (65 percent) is actually low. Just last week we saw several retailers miss on quarterly earnings and revenue projections, which placed a black cloud over the entire consumer discretionary sector.

INTERNATIONAL ETFS FOLLOW-UP

In a past blog I advocated that most retail investors who trade ETFs in the secondary market should limit their universe of funds to those with over $1 billion in assets. Unfortunately, there are several areas of the market (international country funds, agency bonds, international/regional sectors, international bonds and dividend payers) where you won’t find a large fund to play. As you can surmise from the aforementioned list, international-related funds in less liquid markets are harder to find with any size.

For international funds keep in mind some rule of thumb items to consider:

  • Capitalization-weighted country funds are typically weighted towards the country’s large banks and financial stocks.
  • Commodity/energy-based economies (Russia, Norway, and Canada) will typically offer ETFs tied to those industries and bank stocks that provide loans to those industries (possibly doubling your exposure).
  • There are rarely enough small-cap names in many country and regional ETFs to be a large versus small factor. The same goes for growth and value.
  • The corporate fixed-income ETF market is very limited, as most international bond ETFs target sovereign debt. In EM bond ETFs, the debt can be denominated in U.S. dollars or in local currency terms.

Have a wonderful week,

Neil Leeson
Day Hagan Asset Management Investment Committee

— Written 05-19-2016

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