Pinpointing investment prospects

Sector ETFs can be especially helpful for clients who want to tweak their exposure to cyclical and defensive industries at different stages of the economic cycle.

“Sector ETFs are an extremely powerful way to navigate global macroeconomic shifting winds or to play out a more focused view of the areas of the economy that might grow in the future,” says Daniel Straus, analyst, ETFs and financial products, National Bank Financial Inc., in Toronto.

Some hands-on clients may be inclined to invest in individual stocks when they feel confident about the prospects of the companies in a sector. However, doing so exposes those clients to individual stock risk, as well as to far greater volatility as compared with a sector ETF, says Eric Balchunas, senior ETF analyst with Bloomberg LP in Princeton, N.J.

“The upside of ETFs is you diversify away a lot of your risk,” Balchunas says. “In general, in an industry or sector ETF, the volatility of the ETF will be half that of the average stock held in the ETF.”

Clients should consider what’s already in their portfolio before investing in sector ETFs to avoid having too much concentration in specific parts of the market. For example, clients who hold a broad equities-based index ETF in Canada already have hefty exposure to the energy sector and, therefore, may want to refrain from investing in an energy-sector ETF.

“Many Canadian investors have a home bias – they buy mostly the stocks of the companies that are operating out of their backyards – the ones they’re most familiar with,” Straus says. “The concern is that this will imply an energy overweighting.”

Focusing on Canadian equities also means clients are, for the most part, excluding certain sectors from their portfolio. For example, consumer discretionary stocks and health-care stocks are not well represented on the S&P/TSX index. To gain exposure to these sectors, clients could consider investing in such sector ETFs as Consumer Discretionary Select Sector SPDR Fund (NYSE Arca: XLY; sponsored by Boston-based State Street Global Advisors) or BMO Equal Weight U.S. Health Care Hedged to CAD Index ETF (TSX: ZUH; sponsored by Toronto-based BMO Asset Management Inc.).

Clients also need to consider whether they want exposure to an entire sector or to a specific subsector within it. For example, clients who are optimistic about the performance of banks may prefer to invest in an ETF dedicated to banks rather than in a broader financial services sector fund that also may include asset-management firms and insurance firms.

However, clients should be aware that the more focused an ETF is, the more risk and volatility it can carry. Some subsector ETFs are dominated by just a handful of companies, which often are equal-weighted – which, in turn, gives smaller companies greater representation in the fund.

“Subsector ETFs are more focused; they’re more niche. [And] they sometimes are not nearly as well diversified,” says Straus. “[They] may expose you to either concentration risk or small-cap risk.”

The level of volatility in a subsector ETF can be “double or triple” the level of volatility in a broad-sector ETF, Balchunas says. Subsector ETFs also tend to carry higher fees than broad-sector ETFs.

In today’s business environment, cyclical sectors such as technology and financials present attractive opportunities for investors, say both Straus and Tyler Mordy, president and chief investment officer with Kelowna, B.C.-based Forstrong Global Asset Management Inc. Although there are various political and economic risks on the horizon, Mordy adds, governments are shifting away from austerity and are spending money to stimulate growth, which bodes well for cyclical sectors.

“We’re entering a higher-growth phase in the world economy. And, as such, you should adopt more risk in your portfolio,” says Mordy. “I would stay away from the defensives, particularly utilities and telecoms.”

Financials, in particular, are poised to benefit from steps being taken by U.S. President Donald Trump to reduce regulation in that sector. “Deregulation, usually, is good for profits,” Mordy says. He suggests State Street Corp.-sponsored Financial Select Sector SPDR Fund (NYSE Arca: XLF) as an ETF that provides exposure to the U.S. financial services sector.

Health care also is attractive, says Straus: “Over the long term, with an aging population and improvements in technology and health-care provision, we think that a pro-cyclical sector like that is where investors should be looking.” He points to ZUH as an option for clients seeking exposure to the U.S. health-care sector.

Mordy, for his part, foresees strong prospects for biotech companies. He suggests that investors get exposure through State Street’s SPDR S&P Biotech ETF (NYSE Arca: XBI).

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