One way to play the market with a view to outperforming the S&P/ASX 200 index is through sector tilts and this can be relatively easy when using exchange-traded funds (or ETFs).

After all, research suggests that most company stock prices are correlated with general trends in the market – that is, if the market is trending down, even great stocks will have a hard time making gains. Similarly, a rising market will tend to push the price of most stocks up to a degree, even the dogs!

This correlation gets even stronger when we drill down to the sector level. Whether a stock is rising relatively strongly compared with the general market often depends on which sector it’s in. If ‘financials’ are in vogue, for example, then most financial stocks may tend to do well relative to the general market. Ditto resources.

Given these often high correlations, the advent of ETFs makes life even simpler for investors. For example, if you like the financial sector, but are not sure which bank to invest in, you can invest in all of them in a single trade by buying a financials sector ETF. Similarly, if resources are hot, you can avoid having to choose between mining companies by investing in an ETF covering the whole sector.

Financial tilts

As seen in the table below, there are four financial ETFs to choose from – most of which exclude listed property. Of these, the ETF from Beta Shares (QFN) has the most funds under management and appears to be the most liquid. It’s also the cheapest by a slight margin.

Resource tilts

In the resources area, the Beta Shares ETF (QRE) also has the most funds under management, though its average bid-offer spread last month – according to ASX research – was unusually wide. Looking at earlier months, however, Beta Share’s average bid-offer spread is usually no higher than its competitors.

Note that the financials and resources sectors account for around 37% and 33% of the S&P/ASX 200 index, respectively, leaving only one third of the market to other sectors. This suggests that getting the financials versus resource sector call right would go a long way in helping investors beat the market.

Financials vs. Resources

So which sector currently is best? Two handy rules of thumb are that the resources sector tends to outperform when commodity prices are rising, while the financials sector tends to outperform when interest rates are falling. After a very strong run for much of the past decade, export commodity prices – for bulk minerals like coal and iron ore – appear to have past their peak, and the price outlook seems flat to down. Consistent with this, the strong outperformance of the resources sector earlier this decade has flattened out since the global financial crisis.

S&P/ASX 200 Resources

Relative price ratio to S&P/ASX 200 index, with 30-day moving average

This strong outperformance by the resources sector has been offset by the underperformance of the financial sector. Though again, the financials sector has broadly tracked the market over the past year, with a bias toward outperformance since the Reserve Bank of Australia (RBA) began cutting interest rates last year.

S&P/ASX 200 Financials

Relative price ratio to S&P/ASX 200 index, with 30-day moving average

Of course, financials have other challenges, with the banking sector facing margin pressure due to the increase in the cost of borrowing money offshore and the strong local political pressure not to pass these costs into higher lending rates.

Banks are also facing the problem of slow credit growth, with Australian households no longer borrowing to the degree they once were.

Inevitably, the correct sector call depends on the state of the global economy. With global growth likely to be relatively subdued this year, that would seem to favour lower local interest rates eventually and further weakness in commodity prices. This trend should tend to favour financials over resources.

Also favouring financials is the fact that dividend yields in the sector are considerably higher than that available within the mining sector. Local banks also have enough domestic market clout that they’ll probably maintain their healthy profit margins – one way or another – even in the face of political pressure.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

• Peter Switzer: Dr Doom turns to Dr BOOM!
• Charlie Aitken: Australian banks are not what they used to be
• Andrew Bloore: How to use your SMSF to increase your Age Pension