Nasdaq: Room For Many Approaches With Sectors

July 13, 2016

[The following "ETF Industry Perspective" is sponsored by Nasdaq]

Sector investing has been a popular approach over the years. After all, some of the largest and most liquid ETFs on the market are sector-based products, which provide investors broad exposure to a specific sector. And because of their structure as ETFs (which allows them to trade as easily as stocks), the sector ETFs made it very easy to implement various sector strategies.

Sector rotation strategies are rooted in taking advantage of sector performance dispersion during various economic cycles. As the market begins to favor one sector over another, a sector rotation strategy can follow the performance to those in-favor sectors. For example, when the market is in a downturn, defensive sectors (those that are less likely to see their business lines affected, e.g., consumer noncyclicals, health care and utilities) tend to be more appealing, since demand in those areas are fairly steady and somewhat disconnected to the overall economy. An example here would be a sector rotation strategy moving from biotech to utilities in February 2016 to take advantage of the shift to defensive sectors.

Another benefit these indexes can provide is the ability to overweight a particular sector. If an investor located in Australia, for example, wanted exposure to technology stocks that local markets cannot provide, a technology index can allow him/her to change home market dynamics via sector investing.

As the benefits and opportunities around sector investing arise, the types of methodologies applied to the space continue to expand. Sector ETFs today are based on numerous types of indexes. Some are basic exposure or beta indexes, while others are beginning to introduce factors and fundamentals to attempt to increase performance. The constant march forward of technology also means that the market can evolve as new industries develop.

Looking beyond broad sectors, which are fairly uniform across classification systems, it is possible to drill down into more narrowly based subgroups. A narrower focus means that some diversification can be sacrificed in an index, but it also gives the investor the opportunity to hone in on a very specific stream of returns that can enhance the performance of their broader sector exposure.

Nasdaq has taken a leadership role in the sector space with a wide-ranging offering of sector indexes designed for different purposes. The Nasdaq Global Equity Indexes includes U.S. sector indexes based on the Industry Classification Benchmark (ICB). Like all Nasdaq indexes, these sector strategies are designed with objective, rules-based methodologies.

The Nasdaq PHLX® niche sectors are intended to underlie tradable products like derivatives and ETFs, such as the PHLX Semiconductor Index, which underlies the $455 million iShares PHLX Semiconductor ETF (SOXX). The PHLX indexes are designed to provide access to very specific portions of the market via core large-cap stocks. They include indexes covering oil services companies, gold and silver miners, utilities, defense companies and housing-related firms. These very specific subsets of broader sectors can result in more intense exposure and performance.

These “exposure products” are designed to support the tradable derivative, whether that is an ETF or a futures option. They provide an instantaneous diversification into a singular exposure, and do it using a rules-based approach.

Since cap-weighted indexes like these can lead to significant overweights in individual large-cap stocks—like Amazon in the retail segment—especially within the sector space, Nasdaq looks to alternative weighting approaches that can counteract this effect.

Rob Arnott, one of the founders of the smart-beta movement, has said that one of the driving principles of his firm Research Affiliates’ approach is breaking the tie between a stock’s price and its weighting in an index. Aiming to do this in the sector space means that investors can gain yet another angle on their sector exposure by increasing their diversification by combining the alternative weighting approach with a cap-weighted approach. Different stocks will be given different weights. Dorsey, Wright & Associates, a Nasdaq company, which is known for its relative strength and momentum methodology, created a line of smart-beta sector strategies that are the basis of nine Invesco PowerShares’ ETFs that select and weight their sector components based on price momentum.

The Dorsey Wright sector indexes cover the standard nine sectors that are widely used by investors and underlie products offered by Invesco PowerShares. They offer another rules-based angle on the traditional sector viewpoint that complements existing products.

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