Sector ETFs: Highly Classified

June 08, 2011

The classification scheme behind your sector ETF matters more than you think.

Since the first suite of Select Sector ETFs launched in 1998, they’ve been a big hit in the ETF market. Together, sector ETFs account for almost 15 percent of assets in the entire U.S. ETF market and, in terms of trading volume, they’re off the charts. Equity sector funds now make up 25 percent of all ETF volume, and I can’t remember the last time I didn’t see the SPDR Select Retail (NYSEArca: XRT) or the SPDR Select Energy (NYSEArca: XLE) near the top of one of our daily fund flows reports.

It’s no surprise that the funds are popular: They let investors take a stance on the direction of segments of the market without the risk of single-stock picking. People like sector funds for rotation strategies, playing industries that look poised for growth when they’re bullish, and rotating into the more insulated sectors when markets turn down.

How well these funds serve you is all a matter of how they’re built. And, not all sector funds are created equal. Don’t believe me? Look at how the following “plain-vanilla” consumer sector funds stacked up against each other over the past two years:

 

IYK:VCR:XLY Performance

 

Keep in mind, the above chart is only shows straight-ahead, market-weighted funds and doesn’t include the alpha-chasers like the PowerShares Dynamic Consumer Discretionary Sector Portfolio (NYSEArca: PEZ).

So what causes the divergence?

To be fair, there are a lot of pieces to this puzzle—market-cap minimums and depth of holdings, for starters—but an often-overlooked factor is the classification system behind the index. All sector indexes must, after all, rely on someone to herd the vast number of global stocks into their correct industry classifications.

It’s the index providers that do this through their own proprietary industry classification systems. The two big names in the game are MSCI and S&P’s Global Industry Classification Standard (GICS) and Dow Jones’ Industry Classification Benchmark (ICB). These are the systems that are used to build the indexes that big funds like the SPDR, Vanguard and iShares sector funds use. But there’s a third option that’s more popular around here. That’s the Thomson Reuters Business Classification (TRBC), and while it hasn’t yet been deployed in the ETF market, we wrote about why we prefer it in a Journal of Indexes article called “Signal From Noise.”

The classification systems diverge in enough ways that I can only scratch the surface here, but some of the highlights are worth taking a look at.

 

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