Two rules of thumb for sector investing | BetaShares

Two rules of thumb for sector investing

BY David Bassanese | 10 April 2015
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One of the benefits of using equity ETFs is that they enable investors to engage in broad market or sector investment strategies without having to decide which individual stocks to invest in.The question naturally arises: when should one sector be favoured over another? It turns out there are a two handy rules of thumb that might help investors with their deliberations.

If you are positive on the financial sector, for example, the BetaShares S&P/ASX 200 Financials Sector ETF (ASX:QFN) enables one to gain diversified exposure to the whole sector in a single trade – without having to choose between individual stocks such as the Commonwealth Bank or Westpac. Similarly, if you are bullish on resources, the BetaShares S&P/ASX 200 Resources Sector ETF (ASX:QRE) allows you to gain exposure to the whole sector without having to choose between individual mining stocks such as BHP Billiton or Rio Tinto.

First rule of thumb: Overweight Financials when Interest Rates are Falling (and vice-versa)

As seen in the chart below, there has historically existed a broad inverse relationship between the Reserve Bank of Australia’s official cash rate and the relative performance of the S&P/ASX 200 financial sector against the broader market over the past decade or so. This suggests the first simple rule of thumb: overweight financials when you consider we are in a falling interest rates environment; and underweight financials when you believe we are in an environment of rising interest rates. This relationship likely reflects the fact that low interest rates encourage greater borrowing and lending (and visa-versa) and so helps boost financial sector activity. Low interest rates also tend to encourage investors to seek out high-dividend yielding stocks, many of which can be found in the financials sector.

financials

Past performance is not an indication of future performance.

Second rule of thumb: Overweight Resources when Commodity Prices are rising (and vice-versa)

By contrast, the chart below details a broad positive historical relationship between Australian export commodity prices and the relative performance of the resources sector against the overall market. Of course, such a result should not be too surprising, as rising commodity prices are likely to boost the top-line revenue growth for Australia’s mining companies. That said, it is still interesting to note the directness of the relationship i.e. the market tends not to “look through” commodity price cycles when valuing resource stocks – rather share prices tend to closely reflect short/medium-term trends in commodity prices. While there are no doubt many other factors that will determine the correct fair-value for individual commodity stocks, the core role of commodity prices in driving relative sector performance provides yet another handy rule of thumb that “top-down” sector investors can potentially exploit.

resources

Past performance is not an indication of future performance.

Pairs Trading and the Bear Fund

Another potential strategy we have written about previously (here and here) uses the BetaShares Australian Equities Bear Hedge Fund (ASX: BEAR). As we noted before, investors can effectively undertake a “spread” or “pairs” trade using this Fund – gaining exposure to either sector while hedging out overall market risk. For a portion of a portfolio, by allocating 50% of investment capital to the Bear Fund, and 50% of capital to the Financials Sector ETF, for example, investors could expect to generate ‘alpha’ provided the financials index outperformed the market – irrespective of whether the overall market rose of fell over the investment period. Replacing the financials ETF with the resources ETF, investors could expect to generate ‘alpha’ if the resource sector outperformed the market irrespective of overall market performance. In other words, if investors have a strong view that interest rates will continue to fall, they can take a view on the relative outperformance of the sector alone – using a combination of the Bear Fund and the Financials Sector ETF. And if instead investors had a strong view that commodity prices would rise – they can take a view on the relative performance of that sector alone – using a combination of the Bear Fund and the Resources Sector ETF.

What’s our current view? We still favour financials

Our view is that the Reserve Bank will cut official interest rates to as low as 1.5% p.a. this year (from 2.25% p.a. at present), while commodity prices will remain challenged by a rising US dollar, soft Chinese economic growth and rising commodity supply. Overall, our view is that the financial sector is likely to continue to outperform the market over the coming year, while the resources sector may well underperform. Please keep in mind the “rules of thumb” discussed above are indicative only and should be considered along with all other relevant factors when assessing the potential performance of these sectors. Also, the information in this blog is of a general nature only, does not take into account any person’s individual circumstances and is not a recommendation to invest in any financial product or adopt any investment strategy.

3 Comments

  1. Colleen  |  April 15, 2015

    Hi, A very interesting equation, had never thought of this in relation to ETF’s so have Printed your Article above for future Trading Reference!!

  2. Colleen  |  April 15, 2015

    Have NOTED Codes QFN & QRE for Financials & Resources Sectors, respectively, thanking you.

    1. BetaShares  |  April 15, 2015

      Colleen,
      Glad you found this useful. Please let us know if there is anything else you need

      BetaShares

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