How To Find The Best Sector ETFs

• By Simon Maierhofer
• On 1:35 pm EDT, Saturday March 14, 2009

The old adage, 'there is always a bull market somewhere' is yet another piece of Wall Street wisdom that's been rendered obsolete in the past year.

The only bull market to be found is in U.S. Treasuries and short ETFs but let's face it, those are not real bull markets.

A look at the performance of individual industry sectors shows that the bear's appetite for individual sectors varies significantly. For that very reason, savvy sector investors have been known to squeeze out extra returns or cushion the fall compared to the overall market. The emergence of sector short ETFs has added a new, profitable facet to sector investing.

The S&P 500 (AMEX: SPY - News) and most other indexes can be sliced into nine main industry sectors. Each sector represents a portion of the parent index. The Technology Select Sector SPDR (NYSEArca: XLK - News) accounts for 19.9% of the S&P 500 while the Materials Select Sector SPDR (NYSEArca: XLB - News) account for only 3%.

A selective bear

During normal economic cycles, some sectors boom while others bust. Unfortunately there was no booming sector in 2008; still some sectors did better than others. As the composite S&P 500 lost 38.49% in 2008, the Financial Select Sector SPDR (NYSEArca: XLF - News) dropped by 55.21% while the Consumer Staples Select Sector SPDR (NYSEArca: XLP - News) shed a comparatively low 14.98%.

We've stayed clear of the financial sector since the summer of 2007. In fact, in an October 2, 2008 special report we outlined why the government's bailout efforts won't work and brand-marked financials as a 'downward spiral with no stop-loss provision.' We've recommended the ProShares UltraShort Financial ETF (NYSEArca: SKF - News) since August 2007. In fact we warned of Dow 6,700 over a month ago (reports and alerts available to subscribers of the ETF Profit Strategy Newsletter).

Falling harder and faster than the market

Bloomberg created an index of 201 publicly traded companies that received funding through the Troubled Asset Relief Program (TARP). The TARP Index has fallen harder and faster than the financial sector and lost about four times as much as the Dow Jones (AMEX: DIA - News).

Just as you wouldn't want to drink milk past its expiration date, it pays to stay away from sectors about to go sour and gravitate towards sectors with a propensity to cushion the effects of an economic downturn.

On the flipside, if you are betting on a recovery or a sizeable counter trend move, you may want to consider being over weight in high octane sectors bound to bounce higher and faster than the overall market.

Defensive sectors tend to be: consumer staples, health care and utilities. Consumer staples, 2008's best performing sector (-14.98%) was followed by the Health Care Select Sector SPDR (NYSEArca: XLV - News) and Utilities Select Sector SPDR (NYSEArca: XLU - News). XLV lost 23.15%, XLU was down 29.09%.

With the emergence of short ETFs, you may choose to short the worst performing sectors rather than being long the best performing sectors.

How to identify best in class sector ETFs

Even though the Select Sector SPDRs are the oldest suite of sector ETFs, they are not the only ones. iShares, Vanguard, PowerShares, Rydex and First Trust offer full lines of sector ETFs as well.

Each provider takes a different approach to security selection and security weighting, the center piece of any index. Just as the quality of gasoline (or lack thereof) affects an engines performance, security selection and weighting affect the index's performance.

A look under the hood reveals significant differences in make-up and performance. Some ETFs out-or underperformed the Select Sector SPDRs by 25% or more. Let's take a look at the different engines.

Sector ETFs a la Vanguard, iShares and Sector SPDRs use a similar security selection formula. The sector component stocks are drawn from a large market index. The SPDRs use the S&P 500, iShares uses the Dow Jones U.S. Total Market Index while Vanguard uses the MSCI U.S. Investable Market 2500 Index.

As such, the security selection is considered passive' since index components are drawn from the larger index and assigned to the fitting sector bucket. iShares' and Vanguard's parents index is bigger, therefore their ETFs tend to have more holdings.

All securities are weighted according to market capitalization. In short, the largest companies carry the biggest weight in the index. Proctor & Gamble for example accounts for 18% of the iShares DJ US Consumer Staples ETF (NYSEArca: IYK - News).

About engines and horsepower

PowerShares offers two full suites of sector ETFs. Both take a non-traditional approach to index construction.

The PowerShares Dynamic series of ETFs ranks the universe of 2,000 largest stocks for capital appreciation potential according to a proprietary AMEX Intellidex model. Stocks are then divided into two categories containing larger and smaller stocks. 16 of the highest ranking larger stocks collectively receive a 40% weighting while 44 of the top ranked smaller stocks receive a collective weighting of 60%. Within the two categories, stocks are weighed equally.

One of the standouts this Dynamic Intellidex strategy has created is the PowerShares Dynamic Financial Sector ETF (NYSEArca: PFI - News). From the bull market high (Oct. 9, 2007) to the bear market low (Nov. 21, 2008), PFI dropped only 46.12% compared to a 71.90% drop in the Financial SPDRs.

The PowerShares RAFI suite of ETFs selects component stocks according to fundamental measures such as: book value, cash flow, sales and dividends. Stocks are then weighted according to their fundamental scores. This quantitative selections and fundamental weighting system has led to as much as a 32.21% underperformance of the PowerShares FTSE RAFI Consumer Goods ETF (Nasdaq: PRFG - News) compared to the Consumer Staples SPDRs.

Rydex uses the same indexes as the Select Sector SPDRs but weighs all the components equally.

When it comes to sector investing, identifying the best in class sector ETFs might be just as important as the right sector bet. Ideally you want to feed the best engine with the best fuel.

A detailed analysis of the sector ETF line-up from the Sector SPDRs, iShares, Vanguard, PowerShares and Rydex identifies two ETF providers that consistently underperform and two ETF providers that consistently out-perform.

For a comprehensive analysis, the study compared performance numbers during a bear market, bull market and mixed market. In fact, one set of data details the performance of the worst case scenario'. How much money did each sector ETFs lose from the market's 2007 all-time high to the 2008 low?

In a hostile market, investors need to put all odds in their favor to maximize gains and minimize losses. Since the stock market lost over half of its value since the October 2007 peak, the question is whether now is a good time to buy certain sectors.

In addition to a detailed analysis of all sector ETFs with tables, charts and numbers, the ETF Profit Strategy Newsletter has been providing profitable entry and exit points such as Dow 7,500, Dow 9,000 and Dow 6,700. Even the best sector ETFs lose money when bought at the wrong time.

Buzz up!