Improving on ETFs: Get Higher Returns with Lower Risk

I wrote this article six years ago and nothing has changed. There are two important lessons which you will see as you read this. Or, you can skip to the end!

According to the advertising “Why trade one healthcare company when you can trade them all?” It’s a good line and it avoids trying to decide which companies to trade. On the other hand, trading all the healthcare or energy companies includes some that are “not-so-good” and adds risk rather than returns. The SPDRs ETFs weren’t intended to maximize your returns or reduce risk, just to track an industry. If you’re looking for profits, you can do much better.

Capitalization weighting, the way the S&P is calculated, is the way most sector ETFs are constructed. If you want to extract the piece of the S&P that is exactly like the S&P, they have it right. But that doesn’t mean it’s the best way to make money. After all, they are interested in an index, while we’re interested in profits.

Correcting Two Problems

We’re going to make two simple changes to the SPDR sectors, using Healthcare (XLV), and Energy (XLE) as examples.

• Choose the fewest stocks that represent 25% or 50% of the weighting of the index, and ignore the rest.
• Weight them equally, that is, invest the same amount of dollars or euros in each of the stocks

The reasoning behind this is that stocks with the largest weighting have the greatest impact on performance. If the top few healthcare companies post big losses, then it hardly matters what the rest of the sector does, you’ll end up with a loss. That’s not the way diversification should work. Each stock should have the same risk and should contribute equally to the returns.

Over-Diversification

Adding more and more stocks to your index, or your portfolio, will gain some diversification, but less and less. In addition, the first stocks chosen are usually the best, and adding more gives you marginal returns, which lowers overall performance. Picking a few of the best is better than trading a large number of stocks. In the case of the Sector SPDRs, the largest cap stocks are not necessarily the best performers, but we’ll use them anyway to show how this works.

Healthcare (XLV)

In 2016, when this was first written, the Healthcare sector has 57 components. Chart 1 shows the distribution by weight. As you can see, more than half of them have weights less than 1%.

Chart 1. Health Care components in order of descending weight.

Source: www.sectorspdrs.com

We took the top 9 companies representing 51% of the index, beginning with JNJ, shown in Table 1. That makes a manageable number of stocks and allows a small investor to participate, by buying $1,000 of each stock.

Table 1. Nine largest Health Care companies representing 50% of the XLV index.

In Chart 2 we see that an equally-weighted portfolio (each stock gets the same investment) of the 9 largest stocks consistently outperforms XLV.  A quant might argue that there is some ex poste selection here, that is, the largest cap stocks may be the ones that have outperformed others. If that were true, then XLV, which weights those more, would outperform our new portfolio. As we can see, the equally-weighted portfolio gains steadily over XLV. We will look at how the 2016 stocks compare to the 2022 stocks.

Chart 2. Comparison of Health Care (XLV) and an equally-weighted portfolio of the largest 9 health care stocks.

Looking at the statistics, XLV had a 15.9% return with almost the same volatility, giving an information ratio of 1.021. Our new portfolio had a return of 22.0%, volatility of 18.1%, and a ratio of 1.215, a nice improvement.

Table 2. XLV versus a portfolio of the largest 9 equally-weighted stocks.

How It Has Changed

It is now 2022 and the stocks and weighted of XLV has changed. We now have five stocks that remain and four new ones, all with different weights.

Table 3. Top XLV holdings as of April 2022.

If we look at how the 2016 stocks performed, we can avoid being accused of ex poste selection. Chart 3 shows the 2016 stocks and weighting factors carried forward, and Chart 4 shows the new stocks and weighting compared to the XLV and equal weighting. I have also included the 5 stocks with the highest allocation, compared to the 9 stocks from the original test.

Chart 3. Returns using XLV allocations from 2016.

Out-of-sample the equally-weighted 5 and 10 stock portfolios outperform both the XLV and the cap-weighted 9 stocks portfolio. Had we changed the stocks and allocations as we progressed through time, I have no doubt the equally-weighted results would have been far better.

Chart 4. Returns using XLV allocations in 2022.

 Chart 4 shows similar results to the original 2016 test. The equally-weighted portfolio of 9 stocks or 5 stocks outperform XLV and the cap-weighted stocks.

If you plan to do this yourself, look up the first five components of XLV and invest an equal amount in each. The results should be good, but it is not immune to drawdowns. Do not over-invest.

XLE, the Energy ETF

Energy has been the big mover this year, the result of Russia’s invasion of Ukraine. It is not clear how long that will last. The energy market has responded with higher prices, but is now seeing lower demand. Prices are stabilizing for now. I make no attempt to predict the future.

Table 3. (Left) Top stocks of XLE in 2016. (Right) Top stocks of XLE in 2022.

We do the same comparison as with Healthcare. Chart 5 shows how the 2016 weighting factors would have looked now.

Chart 5. Returns of XLE and the 8 top components using 2016 weights.

Next, we look at the returns based on the 2022 weighting factors, shown in Chart 6. While the equally-weighted returns outperform the cap-weighted returns, the two charts look remarkably the same. That is because 7 of the 8 stocks are the same. A change in the weighting factor does little when the markets are all moving because of the same geopolitical factors.

Chart 6. Returns of XLE and the 8 top components using 2022 weights.

The Main Points

The sector SPDRs were never intended to improve returns of those sectors, simply to isolate various industries as benchmarks. A portfolio that is capitalization weighted means that the largest cap stocks must perform best for an investor to capture the best returns. That rarely happens.

Using a large number of stocks correctly isolates the industry performance, but those companies with the smaller weights don’t contribute much and more likely cause over-diversification and lower average returns.

Investors interested in trading a sector should look first at an equally-weighted portfolio of a few stocks with the largest weights in the ETFs. As shown with health care and energy, they will most likely significantly improve your returns. Keep checking the weights so that you always have the top stocks in your portfolio.