Striving to stay with the sizzle

By Tim Middleton

The No. 1 question in investing is always: What's hot right now? Imagine if you could design a portfolio that always had the answer.

That's the goal of a pair of new exchange-traded funds that specialize in trading in and out of different economic sectors. Markets go through cycles that favor different industries at different times. PowerShares Value Line Industry Rotation (PYH, news, msgs) and Claymore/Zachs Sector Rotation (XRO, news, msgs) seek to align themselves with these cycles, buying what's strong and shunning whatever is weak.

Launched less than a year ago, the funds have quickly gained traction. The PowerShares portfolio has advanced 8.9% this year, as of May 16, and Claymore has spurted 9.9%. The S&P 500 Index ($INX), a broad-market index, is ahead 7.5%.

The new ETFs enter a space that has been the province of a mutual fund, Rydex Sector Rotation H (RYSRX), which is up 10.1% this year and over the past five years has consistently ranked in the top quarter of similar funds.

The case for sectors

Some economic sectors can post long winning streaks. In the 1990s, technology and health care dominated everything. More recently, real estate, natural resources and utilities have sparkled.

But within these broad trends, industries can gain favor, and lose it, for more transitory reasons. Last month, I noted the surging performance of SPDR S&P Metals & Mining (XME, news, msgs), which is up a stunning 31% this year and is benefiting partly from seasonal factors.

Funds devoted to sector rotation employ computer models that compare such attributes as strong earnings and rising stock prices to identify those with the best characteristics. That leads, in turn, to identifying the strongest sectors. Then they clump their investments into the hottest areas. The new ETFs use different approaches to seeking out investments and jealously guard the recipes they have created. PowerShares has partnered with Value Line, an enormously successful investment newsletter. Claymore's partner is Zachs Investment Research.

The case for ETFs

Sector-rotation funds trade a lot as they move from one cluster of stocks to another. In a mutual fund, every successful sale generates a tax liability for shareholders. The Rydex fund distributed 44 cents of long- and short-term capital gains to shareholders last December, representing 3.2% of the fund's value at the time.

Similarly, a mutual fund's rotation among individual sector ETFs, such as the Metals Spider, generates commissions as well as capital gains. ETFs trade like stocks throughout the day, and are bought and sold like them.

The new sector-rotation ETFs eliminate both of these friction costs. ETFs don't buy and sell the stocks they hold; they trade for them with institutions in tax-free swaps. Thus their shareholders can switch, for example, into health care without taking any action or paying commissions or taxes.

That's what the Claymore fund did at the end of the first quarter, and its timing was impeccable. "We went from 0% to 20.7% on April 4, and the interesting thing is that in April the S&P 500 Health Care Index was up 7.2%," says Christian Magoon, senior managing director of Claymore Securities. Health care enjoyed its best month since June 2000 and was the top-performing sector last month.

Comparing the ETFs

Since sector-rotation funds operate as black boxes -- how they work is secret -- investors have nothing by which to judge them except the choices they make, the results they earn, their expenses and the reputations of their operators.

Claymore and PowerShares have a big expense edge over their mutual fund rival. Rydex charges 1.66% in annual fees; the ETFs charge almost a full percentage point less. Some share classes of the Rydex fund also generate commissions for the brokers who sell them.

The ETFs do not, however, have a track record. They publish lengthy performance records, but these are for the underlying indexes, not the funds, so they don't include fees. And the numbers they publish are for differing periods and can't be directly compared.

Claymore/Zachs Sector Rotation (XRO)
Sector allocations	Financial services	37.8%
	Retail/wholesale	21%
	Medical	20.7%
	Industrial products	6.3%
	Oil & energy	4.5%
Avg. market cap	$31.78 billion
Stocks held	100
Assets	$65.2 million
Expense ratio	0.6%
YTD performance	9.9%
Historical performance	1 yr	3 yr	5 yr	10 yr
	18.3%	20.7%	14.7%	16.7%

PowerShares Value Line Industry Rotation (PYH)
Sector allocations	Consumer	29.9%
	Discretion	16.6%
	Info technology	13.8%
	Materials	11.7%
	Industrials	8.5%
Avg. market cap	$22.62 billion
Stocks held	75
Assets	$33.79 billion
Expense ratio	0.7%
YTD performance	8.9%
Historical performance	1 yr	3 yr	5 yr	10 yr
	-0.8%	18.9%	13.9%	16.1%

Notes: YTD performance is as of May 16. Historical performance is of the underlying indexes, not the funds, and is as of Dec. 31, 2006, for Claymore and as of March 31, 2007, for PowerShares.

Obviously the two funds identify very different industries on which to focus their bets. But the long-term results they claim are similar. The Rydex fund, which does have a track record, is up an average 17.7% a year over the past three years and 9.2% over the past five.

These are market-beating numbers; the Vanguard 500 Index (VFINX) is up 13.3% over the past three years and 8.5% over the past five. That implies these funds are riskier than the market as well.

Statistical measures of risk such as standard deviation are impossible to calculate on the new ETFs because of their lack of a public track record. The Rydex fund can be studied, however, and it reveals these risks.

The Rydex fund's standard deviation, or price volatility, is indeed higher than the market: some 77% higher than Vanguard 500's for three years and 22% higher over the past five. Also, its r-squared, or sensitivity to market movements, is low -- just 62 on a scale of 100. In that respect it behaves more like mid-cap stocks, which are riskier than big caps.

These risks are statistical probabilities, and the actual performance of these portfolios can defy them. In February's mini-swoon, Vanguard 500 declined 2.0%. The Claymore fund sank only 0.9%, and Rydex 0.8%. The PowerShares fund actually gained 0.8% in February.

But none of these funds has weathered a bear market. Outsize performance usually goes both ways -- these funds could be very disappointing when markets are headed lower.

In sum, a sector-rotation fund is no replacement for a conventional big-capitalization fund in the core of your portfolio. But for zippier money around the margins it can be a useful addition to such usual suspects as small- and mid-cap funds.

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.