Sector ETFs Not Ideal Passive Tools

October 07, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Ellie Lan, an analyst on the investment team at the New York-based automated investing service Betterment.

Exchange-traded funds have seen enormous growth in assets under management over the past two decades. And trading frequency has kept pace.

From July 2014 to July 2015, $18 trillion of ETF shares exchanged hands (to put things into perspective, the U.S. GDP stands around $17 trillion). Considering that the total net assets of ETFs as of year-end 2014 was around $2 trillion, the average turnover of shares in ETFs was more than eightfold.

ETFs provide a convenient and cost-effective way to gain exposure to both broad market indexes and specific sectors. However, some ETFs are more efficient than others. One of the most important ETF distinctions is the active versus passive ETF classification; passive ETFs track a market-weighted index, whereas active ETFs allow managers to deviate from the underlying benchmark with the goal of outperforming the index.

When Passive Is Not Passive

But even that classification gets more complicated; just because something is called a “passive ETF” does not necessarily mean it is best for an investor who subscribes to a passive investing philosophy.

For example, some active managers use passively managed sector ETFs to make sector bets. Although sector index ETFs are themselves technically passive ETFs, they are typically used for active portfolio management.

Achieving a broad passive allocation using a set of highly concentrated ETFs is a common “wolf in sheep’s clothing” approach to asset management, also known as “fund stuffing.” Sector ETFs not only rack up more fees when it comes to expense ratio, internal fund turnover, and bid ask spread, but they also require more work when it comes to rebalancing.

Broad Vs. Concentrated

All ETFs sit on a spectrum in terms of coverage, or how many different assets they include. On one end are broad, market-capitalization-weighted ETFs that passively replicate an index with thousands of constituents. For example, the Vanguard Total Stock Market (VTI) ETF tracks the entire U.S. stock market.

On the other end of the spectrum are highly concentrated and focused ETFs that cover niche markets. One example is the Fidelity MSCI Consumer Staples (FSTA) ETF. FSTA specifically tracks the consumer discretionary sector.

Whereas VTI represents 100 percent of the investable companies in the U.S. equity market and has 3,886 stocks, FSTA has only 386 constituents, or about 10 percent of the stocks in Vanguard’s total market ETF. While FSTA may be classified as a “passively managed” ETF because it tracks an index, a sector ETF is rarely the ideal candidate for a passive broad market tracking portfolio.

Passive Tools For Active

An active investment manager may decide that rather than holding the inexpensive VTI, which doesn’t allow her to underweight or zero-out exposure to market slices she doesn’t like, she’ll build out a portfolio using sector ETFs. This allows her to tactically shift allocations based on her subjective views.

Of course, for sector ETFs to be chosen, they must make up for the additional costs incurred. For example, U.S. sector ETFs have a median expense ratio of 0.45 percent, about nine times the expense ratio of Vanguard’s total stock market ETF, VTI, which costs 0.05 percent.

So right off the bat, the portfolio manager starts with a guaranteed 40 basis point head wind.

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