Can Sector ETFs be used to construct Funds?

(Click on the image to enlarge)

ETF Sectors:
SPY=S&P 500; XLE=Energy; XLF=Financial; XLI=Industrial; XLK=Technology; XLP=Consumer Staples: XLU=Utilities; XLV=Healthcare; XLY=Consumer Discretionary

Laura is interviewing for the Hedge Fund Analyst position.

Question # 1

Interviewer: These graphics have been compiled off Standard and Poor's Exchange Traded Funds (ETF), reflecting daily closing prices between 07/01/2018 and 07/31/2019. Are you familiar with these ETFs?

Laura: Yes, I track and analyze them quite frequently. While SPY tracks the S&P 500 stock market index, the other ones are individual sector ETFs.

Question # 2

Interviewer: Use 5 sector ETFs to construct an aggressive (long only) fund. Weighting factors can range between 10% and 30%.

Laura: I would use XLF, XLI, XLK, XLP and XLY, equally weighted at 20% each. They are all highly correlated so they would move in tandem.     

Question # 3

Interviewer: How come you didn't select a hedge component while constructing the portfolio?

Laura: Because I was asked to construct an aggressive (long only) fund. An aggressive (long only) fund generally excludes hedges or negatively correlated components. 

Question # 4

Interviewer: In continuation of the prior fund construction, develop a weighted balanced fund where the dividend yields proxy fixed income assets. 

Laura: I would select the three equally-weighted stock ETFs, i.e., XLF, XLK and XLV with low multi-collinearity and the two equally-weighted high yield ones, XLP and XLU, surrogating fixed incomes. 

Question # 5

Interviewer: Why did you skip XLE despite yielding the highest dividend?

Laura: Since it has the highest beta, it's the most volatile one in the mix. Ideally, the balanced funds should try to minimize the use of highly volatile asset classes and components.  

Question # 6

Interviewer: Now, construct an income fund, with minimum volatility and maximum income. 

Laura: In constructing the income fund, I would use variable weights. My fund would include 30% XLU, 25% XLP, 20% XLF, 15% XLV and 10% XLK, respectively.  Again, though XLE has the highest yield, it is also the most volatile, hence skipped.

Question # 7

Interviewer: Is there an alternate use of these 3 funds?

Laura: Yes, as Fund of Funds; for example, for a low risk investor, the income and balance funds could be heavily weighted while the aggressive fund could contribute marginally. Similarly, for someone without any appetite for risk, the aggressive fund could be avoided altogether.

Question # 8

Interviewer: So, what's the use of these sector ETFs when SPY can represent them all?

Laura: SPY represents all the major sectors of the economy, so it's more or less an all of all index. The fund managers cannot use it to address clients' specific investment objectives or levels of risk tolerance. The sector ETFs can help achieve those goals.    

Question # 9

Interviewer: Finally, do you think ETFs have any special advantages over the competing Mutual Funds?

Laura: Yes, ETFs provide a number of advantages over the competing Mutual Funds. Here are the three most important ones: (a) ETFs have significantly lower expense ratios, e.g., all of these sector ETFs have under 0.15% expense ratios as compared to the usual 1-3% for Mutual Funds; (b) ETFs can be self-directed, while Mutual Funds are managed by dedicated managers; and (c) ETFs have no additional sales commissions, while all actively managed funds (generally sold by brokers and private managers) carry loads, making them quite expensive.

    

Interviewer: Did you learn all these at school?

Laura: No. My mom taught me. She is a consulting Economist.

"Well, that says it all."

Disclaimer - The author is not advocating the ETFs listed here. Consult your Registered Rep, RIA or Financial Planner for an appropriate asset allocation model and the suitability of stocks, indices and other holdings for your portfolio.

Good Luck!

Sid Som, MBA, MIM
President, Homequant, Inc.
homequant@gmail.co

Coming soon ... Sid's New Book: Modern Interviewing Techniques and Skills - Live Simulations with actual Market Data