Will These Sector ETFs Continue to Outperform?

Source: Thinkstock

Source: Thinkstock

With the advent of ETFs over the past several years, a common investing strategy has been to ignore individual companies in lieu of sector ETFs. The idea is that it takes a lot more effort to determine if, for instance, ConocoPhillips (NYSE:COP) is a solid investment than it is to determine whether oil and gas producers more generally make for good investments, because in order to determine the quality of an individual investment, you need to determine if oil and gas producers are quality investments. You need to do a lot more work to determine the quality of the individual stock, and at the same time a great deal of its rise or fall is sector dependent. Why does that work when you can devote your effort to something else?

Of course, if you are a good stock picker and you like to make investments based on managements or reading balance sheets and income statements, you should probably remain a stock picker. But if your thinking is macro-oriented, then sector ETFs allow you to focus on developing your macro-economic outlook.

With this in mind, I think investors who want to incorporate some sector ETFs into their portfolios should consider this year’s winners to date. These funds have been trending upward while the stock market has been flat to slightly higher. If stocks remain strong, as they have been in May, I suspect that these funds will continue to be leaders. I should note that two of them are interesting choices for investors looking for “safe-haven” assets that aren’t highly correlated to the broader stock market.

Source: Thinkstock

Source: Thinkstock

1. The SPDR Oil and Gas Exploration and Production ETF (NYSEARCA:XOP)

Oil and gas have been very strong this year, and a beneficiary of this has been the XOP. This fund is up 10 percent year-to-date. It has also been an outperformer longer term. Since its 2007 inception, it has risen 106 percent versus the Dow Jones Industrial Average, which has risen just 51 percent. This fund holds a wide variety of energy stocks from Goodrich Petroleum (NYSE:GDP) to Anadarko Petroleum (NYSE:APC). These are typically smaller names than the typical large integrated names such as Exxon Mobil (NYSE:XOM), but they are also going to me more leveraged to the prices of oil and gas because they don’t have refining businesses. Therefore, if you want exposure and leverage to oil and gas prices, the XOP is a good way to get it.

This fund is relatively inexpensive compared to the S&P 500. For instance, it trades with a lower price to book value at just 1.95 times book. The S&P 500 trades at over 4 times book value. Also, it trades at about 18 times earnings versus the S&P 500, which trades at 22 times earnings. Investors looking for dividends should look elsewhere, however, as the dividend yield of this fund is less than 1 percent.

Note that an interesting alternative is the Energy Select Sector SPDR (NYSEARCA:XLE), which holds the large integrated oil names as well as many of the members of the XOP. It has a higher dividend yield, but it isn’t going to generate the returns that XOP will generate in a strong oil price environment.

Source: Thinkstock

Source: Thinkstock

2. The Utility Select Sector SPDR (NYSEARCA:XLU)

Of the funds in the Select Sector SPDR family, this has been the best performer for the year. Over the past couple of weeks, it has pulled back, but it is still up over 10 percent year-to-date, and I think that the pullback presents investors with an opportunity. Investors flock to utility stocks when they are concerned about more economically sensitive stocks. These companies have stable and consistent income streams, and they pay a great deal of their profits out in the form of a dividend. This fund yields about 3.5 percent, which is nearly twice the yield of the S&P 500. The XLU also trades with a lower price to earnings ratio of under 17. This fund won’t make you a ton of money, but in a slow and sluggish market it will perform well, and in a down market its losses will be minimal.

Source: Thinkstock

Source: Thinkstock

3. The Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ)

Gold miners were a lousy investment in 2013, but they started 2014 with a bang. So far year-to-date, the GDXJ is up over 12 percent. While one might argue that this is a dead cat bounce, the gold price seems to have hit a double bottom at $1,200/ounce, and if the gold price moves higher so will the depressed junior gold miners. The companies in this fund are typically small companies with valuations in the hundreds of millions, or maybe around $1 billion. They often have 1 or 2 operating mines, so they are riskier than the large gold miners out there. However, a lot of these companies fell 80 percent in value last year or more, and if the gold price rises, they can easily double or triple. They are also potential takeout targets for the large miners.

Expect rapid price swings — both up and down — and consider buying on weakness. Recently, the gold price and the GDXJ share price have been consolidating in a narrow range. I suspect the next move is higher, so consider buying around $34/share.

Source: Thinkstock

Source: Thinkstock

4. The Healthcare Select Sector SPDR (NYSEARCA:XLV)

This fund, like the XLU, is somewhat defensive. If consumers have less money, they may forego a new electronic gadget in order to save money, but they will spend money on healthcare. So with the market jittery this year, this healthcare ETF has risen nearly 7 percent. Not bad for a low-beta sector. Investors should note that the largest companies in this fund, which include Johnson and Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), and Merck (NYSE:MRK) all have strong steady cash-flow streams and pay sizeable dividends.

Going forward, these stocks could be beneficiaries of the fact that Baby Boomers are aging, and they will demand more healthcare, especially as more of them qualify for Medicare. Thus, I think it is important for investors to have a position in healthcare stocks. Since these companies make products that are often very difficult for the average person to understand, an ETF is probably the way to go.

Disclosure: Ben Kramer-Miller is long Exxon Mobil.

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