The U.S. stock market is rallying to new highs, consumer sentiment is rising and the U.S. housing market remains on a healing trajectory, but defensive sectors are leading the charge on the S'P 500, with health care, consumer staples and utilities bringing in the biggest year-to-date returns.
Historically, defensive stocks tend to outperform the broad equities market when investors perceive trouble ahead. But this time, investors still soldiering through the ultra-low-rate environment following the financial crisis are using sector-focused equity ETFs as the next best thing given the paltry yields in many parts of the bond markets.
"This year, there's something new happening, where nongrowth stocks are being pushed up toward growth multiples because of their ability to substitute for expensive bonds and return lots of cash," Joshua Brown, VP of investments for Fusion Analytics and an avid blogger, told IndexUniverse. "We are all aware of the long-term outperformance of lower-beta names, and we know that it works because people tend to overpay for growth and are inevitably disappointed as growth premiums fade."
Jonathan Citrin, founder of Birmingham, Mich.-based registered investment advisor CitrinGroup, goes a step further than Brown, calling the buying of sector funds the latest example of "irrational exuberance" in a market that is getting ahead of itself given shaky fundamentals.
"It's far more likely that negative real returns on sovereign debt coupled with considerably easy monetary policy has pushed many global markets to all-time highs," he said. "Investors willing to put money at risk are doing so out of an emotional greed, without tiptoeing into defensive stocks only."
Whatever the reason for the outperformance, investors who have bought into sector funds like the Health Care Select Sector SPDR (XLV), up 19.6 percent year-to-date; the Utilities Select Sector SPDR (XLU), up 18.3 percent year-to-date; and the Consumer Staples Select Sector SPDR (XLP), up 17.5 percent year-to-date, have so far done better than those simply owning the S'P 500.
The SPDR S'P 500 ETF (SPY) is up just 11.8 percent so far this year, even as it reaches record highs.
XLV, the health care fund, has by far been the most popular of the nine Select Sector SPDRs this year—a roster of funds that slice and dice the S'P 500 into nine sectors—with net inflows of more than $1.3 billion in roughly four months.
By comparison, other defensive sector ETFs such as the consumer staples fund XLP has attracted a net of $533 million while the utilities fund XLU has snagged just under $80 million year-to-date. All the while, SPY has bled $5.87 billion.
"We've been overweight defensive, value stocks for two years," Fusion Analytics' Brown said. "We are now far more interested in the cyclicals, which are hated—there's not even a pure-play chemical sector ETF yet."
"Once the market gets bored of paying 20 times earnings for candy companies and utilities, we'll be waiting for the rotation," he added.
Sector Investing Turns 15
The divergence in performance of the nine sectors is a good reminder of why sector investing is often heralded for allowing investors to effectively express tactical views on the macroeconomy and on business cycles.
It's an investment strategy that works particularly well in shorter time periods, IndexUniverse ETF analysts Paul Baiocchi and Paul Britt pointed out in an article published in the Journal of Indexes last fall that looked into the difference between sector investing and style investing.
"The sector viewpoint provides granularity in risk management and return opportunities relative to style," they said in the article. "The difference in returns among sectors remains far greater than among the style indexes, supporting the notion of tactical sector allocation."
There's no better example of that dynamic than a look at the Select Sector SPDRs which, while not the only family of sector ETFs available to investors, were pioneers in the space. They were the first to slice and dice the S'P 500 into nine investable sectors 15 years ago.
The Sector SPDR Trust first came out of a joint effort in the late 1990s with Merrill Lynch, the American Stock Exchange and State Street Global Advisors, and it is still run today by the same five-person board who founded it.
Since inception, the suite of nine ETFs—which, combined, represent the S'P 500 as a whole—have amassed more than $60 billion in assets, and have come to be known for their massive liquidity. Rising assets have helped push down expense ratios from their original 0.65 percent level 15 years ago to 0.18 percent today.
What's more, the sector SPDRS—celebrating their 15 th birthday later this year—were some of the first ETFs to attract both institutional and retail investors alike, ALPS' Dan Dolan, one of the brains behind the funds, told IndexUniverse. ALPS has been the distributor of the Sector SPDRs from inception.
"The liquidity that sector SPDRS provide is something that really started out on the institutional side, and then the private guys built on that," Dolan said.
"If you go back to 2008-2009, for instance, and the really choppy markets, we were trading as many as 290 million shares a day of Sector SPDRS," he noted. "Last year, we traded 135 million shares a day of the nine sector SPDRs combined. And all nine traded with pennywide spreads."
The funds vary in size, performance and year-to-date flows, as noted below:
- Consumer Discretionary Select Sector SPDR (XLY), up 14.8 percent year-to-date, has gathered a net of $373 million since the beginning of the year. The fund has tallied gains of 18.7 percent in past 12 months and has total assets of $4.4 billion.
- Consumer Staples Select Sector SPDR (XLP), up 17.5 percent year-to-date and up 19.7 percent in the past one year, has attracted a net of $533 million in assets since Jan. 1, 2013 and now has $6.5 billion in total assets.
- Energy Select Sector SPDR (XLE), up 9.1 percent year-to-date, is the only one of the nine sector SPDR funds to bleed assets in 2013, with net outflows of $161 million year-to-date, as it posted relatively modest returns of 9.1 percent in the same period. The fund, which has total assets at $7.7 billion, is 10.1 percent higher in the past one year.
- Financial Select Sector SPDR (XLF), up 13.8 percent year-to-date, has seen the second-largest year-to-date inflows of all nine funds, at $1.01 billion, making it the largest of the Sector SPDRS, with total assets under management of $11.7 billion. The fund has rallied 20.25 percent in the past 12 months.
- Health Care Select Sector SPDR (XLV) is currently the best-performing of the nine funds year-to-date, with gains of 19.6 percent, and is the leading net asset gatherer, with inflows of $1.31 billion in the same period. The fund, which is up 27 percent in the past one year, has $7.1 billion in total assets.
- Industrial Select Sector SPDR (XLI) is up 9.3 percent year-to-date, having now attracted a net of $106 million in the same period. The fund has gained 11 percent in one year and has $4.5 billion in assets.
- Materials Select Sector SPDR (XLB) is right now the worst-performing of the Sector SPDRS, with gains of only 5.2 percent year-to-date, and net inflows of $138 million since Jan. 1, 2013. The fund is also among the smallest, with under $3 billion in total assets. XLB is up 7 percent in the past one year.
- Technology Select Sector SPDR (XLK) is another member of the bottom performers, with gains of only up 5.6 percent year-to-date, and only 1.5 percent in the past 12 months. Still, the fund has attracted a solid $764 million in the past four months, making it the third most popular of the Sector SPDRS of 2013 to date. XLK has a total of $9.5 billion in assets.
- Utilities Select Sector SPDR (XLU), up 18.3 percent year-to-date, has seen net inflows of only $79 million despite its second-best year-to-date performance relative to other sector SPDRS. The fund is up 16 percent in one year and has nearly $6 billion in total assets.
The SPDR S'P 500 ETF (SPY), for comparison, is up 11.8 percent year-to-date, and 13.45 percent in the past year.
|Sector ETF||Ticker|| YTD
|Health Care Select Sector SPDR||XLV||$1.31B||$7.1B||19.60%||27%|
|Utilities Select Sector SPDR||XLU||$79M||$6.0B||18.30%||16%|
|Consumer Staples Select Sector SPDR||XLP||$533M||$6.5B||17.50%||19.70%|
|Consumer Discretionary Select Sector SPDR||XLY||$373M||$4.4B||14.80%||18.70%|
|Financial Select Sector SPDR||XLF||$1.01B||$11.7B||13.80%||20.25%|
|Industrial Select Sector SPDR||XLI||$106M||$4.5B||9.30%||11%|
|Energy Select Sector SPDR||XLE||-$106M||$7.7B||9.10%||10.10%|
|Technology Select Sector SPDR||XLK||$764M||$9.5B||5.60%||1.50%|
|Materials Select Sector SPDR||XLB||$138M||$3.0B||5.20%||7%|
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