Global Sector Investing In Early Stages

August 11, 2015

[This article originally appeared in our August issue of ETF Report.]

In an investment universe that's becoming increasingly worldly, it's no surprise that investing in sectors globally is coming increasingly into focus.

In some ways, going international is a logical stepping stone from the huge franchises of domestic sector funds that have clearly captured the imaginations of U.S. investors. And yet globally focused sector investing—"global" means everything, as in U.S., non-U.S. and even emerging market companies, while "international" means securities excluding the U.S.—while growing in popularity, isn't exactly going gangbusters. One reason is because home-country bias among U.S. investors continues, with ETF assets in domestic strategies still about three times as plentiful as those in international.

Tried-And-True Bias
But even among those investors who have shed home-country bias and are pushing systematically into the international realm to diversify, there remains a tendency to stick to approaches of previous generations. That has slowed the adoption of international sector investing.

All of this isn't to say that global sector investing is a nonstarter. But it may take a few years for all the stars to align for it to become just another approach among several.

"We don't always invest in sectors," said Richard Bernstein, chief executive officer and chief investment officer of Richard Bernstein & Co. "What we have to do is try to figure out where we're going to get the biggest bang for our buck. Sometimes that will be sectors; sometimes that will be countries; sometimes it may be dividend yield; sometimes it might be quality; sometimes it might be domestic versus foreign."

Good Reasons To Focus On Sectors
Those who do invest internationally using sectors as an organizing principle swear by it, arguing it's an effective way to more carefully manage risks in a world that has become increasingly globalized.

"As the world has flattened, you have to consider what's going on around the world with different companies," Corey Hoffstein, chief investment officer and co-founder of Boston-based Newfound Research, said, referring to firms like Apple and Samsung or Exxon Mobil and Royal Dutch Shell, which are global competitors in the same global industries.

"So if you want to take the market temperature of market risk for a given sector, you really can't just look locally anymore. You have to say: I'm going to look at all these companies everywhere," said Hoffstein, whose firm uses iShares' family of global sector funds in a number of its portfolios. To be clear, "global" means these funds include firms from all over the world, including in the emerging markets.

For Hoffstein and Newfound, investing in sectors is about fine-tuning risks in the name of enhancing returns—particularly avoiding problems that could lead to big portfolio losses.

"We believe a lot of risks and bubbles in the market tend to manifest in an industry or a sector," Hoffstein said. "It's a tech bubble; it's a housing bubble; it's a financial crisis. These things have global effects, but they tend to start in a certain sector, and other sectors tend to be safe. Investing in global sectors gives us the ability to finely tune our portfolio to where we see there's safety in the market."

Some Work Better Than Others
Still, there's a fairly consistent sense among advisors and analysts that some sectors probably "work" better than others in the international context.

What makes domestic-sector investing work is that the U.S. economy is cohesive enough for each sector to be subject to the same economic, social and political forces. So it is that financial stocks have tended to predictably recover first after a downturn, followed by sectors like consumer durables and materials later in the recovery cycle.

Sectors like energy or technology clearly have global resonance that's very accessible to U.S. investors. Apple, Samsung and even Sony are companies that are clearly subject to the same economic forces, making global technology sector funds like the iShares Global Tech ETF (IXN | A-88) or the iShares Global Energy ETF (IXC | A-90) easy stories to convey.

"All the sectors internationally make sense to some degree," said Nicholas Colas, chief market strategist at trading technology firm Convergex Group. "But some are easier stories to tell. Global energy is very easy, because the price of oil is a common factor to a lot of that sector. Also, with global technology, everybody gets the revolution that technology is creating, so it's easier to explain."

Sectors like utilities or health care in other countries—which may be subject to very different forces and regulations than in the U.S.—are more difficult for investors to get their heads around and to organize.

The Problem With QE
A deeper problem with sector investing these days is the extraordinary role that central banks have been playing in the macroeconomy since the market crash of 2008-2009, according to Colas.

Sector-based approaches to investing are based on historical price patterns, suggesting that about half of a given security's price movement is due to particular dynamics within an industry, sector or company, while the other half is pure beta, or the movement of the entire market.

The problem is that in the past six years, central banks around the world, led by the Federal Reserve in the U.S., have significantly distorted this 50/50 balance. In the U.S., for example, the correlation between a given security and the market rose to as much as 95% in the post-financial crisis days of quantitative easing. That has made sector-based investing a much tougher row to hoe, since the relationship of when particular pockets of the economy exhibit strength has been altered.

"In the '90s, every fundamental portfolio manager kept a list somewhere on their wall that showed what sectors to be watching for at various points in the cycle," Colas said. "Early in the cycle were financials and consumer durables; midcycle was technology; and late cycle was materials. They played their playbook based on where they thought they were in the cycle. That playbook got thrown out with QE when correlations went so high."

Good News And Bad News
The good news—in the U.S. at least—is that correlations are now about 75%, meaning that sectors are starting to behave like sectors in the context of recovery.

"Just look at financials in the U.S.—they're starting to work better. We're starting to hear about more fundamentally positive calls on financials. At Convergex, we're starting to see a lot more interest in financials among our institutional clients than we have in the last five years. That shows you a real-world example of what happens when correlations break up: The yield curve steepens and there's interest in financials," Colas said.

The bad news is that while the long arm of the Fed may be moving out of the markets, the Bank of Japan and the European Central Bank are still engaged in quantitative easing, which is hurting the prospects for international sector investing. The QE is raising correlations and, moreover, the U.S. and non-U.S. cycles are out of sync.

"If cycles are perfectly aligned, it makes it much easier to play a global sector ETF. If they're not aligned—and they're not right now—it makes it much more difficult," said Bernstein, arguing there are better ways to access international stocks than through sectors.

Product Toolbox
This QE distortion might explain what some see as a relatively slow adoption of international sector investing. It also might explain why iShares closed an entire lineup of international sector funds at the beginning of 2014 that wasn't gathering assets.

A similar lineup of funds from State Street Global Advisors was first to market, and there didn't seem to be enough interest to sustain two product lines. The SSgA lineup has generated some interest, but the real action in the ETF market seems to be in "global" sector funds.

iShares has an 11-fund global lineup—the one Newfound Research's Corey Hoffstein uses—that collectively has more than $7 billion in assets under management. SSgA has two global sector funds—real estate and natural resources—that together have more than $2.5 billion.

The idea of accessing sectors via globally focused funds is compelling to the extent that it makes access relatively efficient. That matters because these funds generally have higher expense ratios than single-country funds or broad indexing vehicles. They also have wider trading spreads and liquidity is lower, meaning drift from net asset value is more of a problem, Hoffstein says.

"What I argue is that by using global sectors, we're able to make more finely grained risk decisions. For example, most of the sectors do move together, but from time to time you do see significant divergence," Newfound's Hoffstein said, stressing that, last year, his sector-focused approach afforded him the opportunity to avoid the global collapse in energy prices.

Still Catching On
However, international or global sectors have yet to see success and popularity in the U.S. that is anywhere near that of domestic sectors.

At the same time, a broad China fund like the iShares China Large Cap ETF (FXI | B-38) won't solve the problem either. Who knew half the portfolio is allocated to financials?

"International sector investing hasn't taken off because that's not how U.S. investors tend to think about the outside world, and they naturally gravitate toward countries," said Nick Good, a senior managing director at SSgA. "The key thing is knowing what you're buying, and from my discussions with investors and advisors, most of them think they're buying something other than what they are."

Whether it's a blessing or a curse, the ETF industry is only too happy to serve up new funds—and, from the looks of it, sector investing promises to be one of those vibrant pockets of product development.

According to Convergex's Colas, it's all about laying the groundwork for the day when the financial crisis is truly in the rearview mirror.

"If you take as the foundation-thought that sector ETFs work best when correlations are declining, then what I see from all those product introductions is that ETF sponsors are already planning for the next phase of capital markets structure once all these central banks have moved to the sidelines," Colas said. "My top-of-the-house observation would be that the growth of sector ETFs domestically and internationally is basically a play on a post-QE world."

 

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