Getting Tactical with Sector ETFs

Heightened demand for sector ETFs

To say markets were volatile in the first half of 2022 would be an understatement. In addition, as of Friday June 30, U.S. stocks had their worst first-half year since 1970, as the S&P 500 sank by 21%.

High inflation — plus aggressive tightening by central banks — have caused pullbacks in asset values. We also saw oil prices surge due to Russia’s invasion of Ukraine and renewed demand from economic re-openings — which in turn caused a ramp-up in production costs, other commodity prices and ongoing supply chain issues. 

As a result, we’ve seen growing demand for sector ETFs, as portfolio managers seek ways to be more tactical and targeted in their allocations by, for example, adding commodity exposure to their holdings. Sector ETFs can also help investors get tactical in a hurry, allowing them to quickly over- or underweight sectors with a single trade as the market evolves. The chart below provides an excellent overview as to which sectors tend to generate alpha during each stage of the economic cycle, offering investors a good baseline from which to start their analysis.

How to use sector ETFs across market cycles

Tracking inflows to sector ETFs

Technology and growth-oriented stocks have led the pack for several years, but lately we’ve seen investors rotate away from this paradigm and move in a new direction. Over the first two quarters of the year, Energy and more defensive sectors — such as infrastructure, utilities and consumer staples — have outperformed the broader market on a relative basis.

Of those aforementioned sectors, Energy is the only one that’s considered cyclical, meaning that it typically underperforms during a market slowdown. Case in point: U.S. crude oil future tanked in 2020 at the beginning of the COVID-19 lockdowns, going as low as minus $40 at one point because: a) everything was closed and oil demand shrank considerably, and b) investors perceived that a bear market was on the horizon. That bear market turned out to be short-lived, and oil prices quickly bounced back, but that moment is illustrative of how oil prices typically perform during economic slowdowns.

This time appears to be different. The conflict in Ukraine and other supply-side shocks have driven oil prices higher in recent months. In fact, the chart below shows that our equal weight oil exposure, ZEO, was an outlier in performance for both 1-year and 3-months because demand continues to grow and supply remains stuck in neutral. Even oil-producing countries that are free from conflict, such as those in OPEC, are not speeding up production fast enough to match demand.¹ In the U.S., where gas prices are cresting $5 a gallon, the situation is so dire that U.S. President Joe Biden had to release a letter urging oil producers and refiners to increase higher production levels.²

Industry sectors

Contrast energy with other sectors of the market. Areas like technology, U.S. banks and consumer discretionary have suffered the most from interest rate hike policies. But it remains to be seen whether monetary policy tightening to reign in the effects of years of quantitative easing (and now stubborn inflation) will result in a recession and ultimately the beginning of a new market cycle.

Capitalizing on opportunities outside of Canadian equities

In all of these scenarios, sector ETFs remain excellent tools to tilt your portfolio without making significant changes to the core, high conviction holdings. Rather than having to radically reform your strategic allocation, ETFs allow for targeted, complementary investments that can be easily added or removed to suit changes in the economic cycle. 

The ease of implementing precise exposures can be an enormous advantage to family offices and investment counsellors who specialize in managing portfolios of Canadian stocks, especially given that relative performance between asset classes tends to differ wildly from year to year. Canadian equities have certainly been a bright spot in this year’s volatile markets so far, but that’s not necessarily predictive of how they will perform going forward. As shown in the chart below, Healthcare went from being the bottom of list in 2016 to the top-performer in 2018, and the only differences were the macroeconomic conditions at play, such as when the Federal Reserve began raising rates. 

Sector ETFs that offer global exposures may be a more efficient and practical way to pivot portfolios tactically than researching and buying individual names, which is itself a resource-intensive approach to investing. This way, family offices and investment counsellors do not have to shift away from their core competencies in order to add satellite sector exposures when market conditions warrant a change in position. 

Sector returns by year (2011−2021)

The case for equal weighting

Instead of allocating by market cap, which can result in a size tilt in the portfolio, our sector ETFs use equal weighting across a basket of high-quality names. This provides ample diversification while also reducing concentration and tends to enhance performance over time. Meanwhile, regular rebalancing of the strategy ensures that holdings that are doing well can be sold high, and that the proceeds can be reinvested to keep the slit even across the holdings. 

For highly concentrated markets and sectors, such as Canada, for example, equal weighting is a powerful index construc­tion methodology both to mitigate individual security concentration and to properly diversify sector exposures. This approach can also help increase dividend yield and total returns over time. 

Being able to respond tactically during times when the market is in flux is critical to maximizing the value of your portfolio. That means being able to increase or decrease exposure to a variety of equities based on sector, region, etc., in order to respond to shifting market conditions. 

BMO offers a robust tool kit of sector ETFs, ranging from Canadian to US to global, from defensive to cyclical, and from equal weighted to cap weighted — all of which can help portfolio managers to target precise segments and make tactical shifts to efficiently respond to changing market environments.

Please contact your BMO ETF Institutional Specialist to learn more about how our Sector ETF products can help you add alpha for your clients. Our Portfolio Managers are also available to help with trading insights. They can also be reached at 1−877−741−7263.

Source: Morningstar Direct, June 30, 2022.

Early recovery

Mid-cycle

Late-cycle

Recession

MERs as of Dec 31 2021.

BETA is a measure of the volatility - or systemic risk - of a security or portfolio compared to the market as a whole

* 3-year historical beta, as of Feb 28, Bloomberg.

**During the last year the management fee of this ETF was reduced. The adjusted MER is 0.28% and represents an estimate of what the MER would have been had the change been in effect during the full financial

¹ Maciej Kolaczkowski and Amy White, ​“Why do oil prices matter to the global economy? An expert explains,” World Economic Forum, February 16, 2022.

² Pippa Stevens, ​“Biden tells oil companies in letter ​‘well above normal’ refinery profit margins are ​‘not acceptable’,” CNBC, June 15, 2022.