ETF Rebalancing Act

A new fund overweights certain sectors.
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New exchange-traded funds seem to get narrower and narrower all the time as their sponsors try to offer something different.

A case in point is the

Claymore/Zacks Sector-Rotation ETF

(XRO)

, which was launched in September by Claymore Investments. It mimics an index maintained by Zacks Investment Research that overweights sectors with the potential to outperform the

S&P 500

on a risk-adjusted basis.

The index's criteria for selecting sectors and stocks are proprietary, but it invests in 100 stocks out of a universe of the 1,000 largest companies traded in the U.S., including American depositary receipts.

Claymore says on its Web site that the index -- and by extension, the fund -- strives to "overweight cyclical sectors prior to anticipated periods of economic expansion and overweight noncyclical sectors prior to anticipated periods of economic contraction."

The process of sector allocation, constituent ranking, reconstitution and rebalancing is repeated on a quarterly basis.

It is important to realize that "underweight" can actually mean zero weight. As of Aug. 31, the index had exposure to just eight of the 16 sectors it follows. In the 10 years for which back-tested data are available, there have been times when the index has had exposure to just six sectors.

It seems unlikely that there will be dramatic upheavals in the fund's holdings every quarter, though there could be noticeable changes every so often. Economic cycles don't often change dramatically in three-month intervals.

Although there are some drawbacks to owning the fund, the results of the back test are very compelling.

Over the last 10 years, the S&P has averaged 8.49% per year, while the sector rotation strategy has returned an averaged 16.23%, according to Zacks. Both numbers include reinvested dividends.


The primary drawback of owning the fund is the potential for sector rebalancing to change its makeup. The fund can allocate between from zero to 45% of its assets to any of the 16 sectors. That means the allocation to a single sector could, in theory, go from zero to 45% with a single rebalancing. While it's unlikely, that could leave you with a lot more exposure to a particular sector than you might want.

As of Sept. 30, the fund's three largest allocations were to financials, energy and retail/wholesale at 39%, 18% and 18%, respectively. So these three sectors accounted for 75% of the funds' holdings.

The fourth quarter rebalancing represented a big change from the third quarter, when the financial sector's weighting was just 26% and the energy sector didn't even rank in the top three.

The fund's methodology for weighting individual stocks can be a little confusing. Once the sectors are selected and weighted, Zacks then screens for the best stocks from each of those sectors. Stocks that make the cut are then grouped into different tiers based on market capitalization, with large-cap companies weighted more heavily than smaller-cap companies.

So Goldman Sachs

(GS) - Get Report

, which accounts for 1.78% of assets, is weighted more heavily than Raymond James Financial

(RJF) - Get Report

, at 0.35% of assets, because Goldman Sachs has a bigger market cap than Raymond James, not because the proprietary model prefers Goldman Sachs over Raymond James.

One thing that I think you can count on with this fund is a large-cap bias. The ownership universe is from the largest 1,000 companies. The current average market cap of its holding is $23 billion; this is large but not mega (with mega as defined as companies greater than $100 billion).

But it's probably not worth trying to anticipate how the fund's holdings may change from quarter to quarter; just try to stay current on the changes as they happen.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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