Equity Sector Investing - Taking a Look at the ETFs

January 26, 2004

Examining the Exchange-Traded Funds Options. Author says competition is good for sector fund shoppers and competitors.

Executive Summary

Equity sector investing refers broadly to long and/or short sector investing by asset owners, professional portfolio managers, and risk managers, based on a strategic orientation to sectors (as distinguished from individual securities) and implemented through transactions involving exchange-traded funds (ETFs).  The growth of equity sector investing during the next five years will be propelled and/or hindered by the numerous forces: people (asset owners, portfolio managers, and risk managers), investment consultants, philosophies, paradigms, investment perspectives, security analysts, portfolio managers, information technology, portfolio products, performance evaluation, competition, and the availability of exchange-traded funds and options on ETFs.  Equity sector investing is a logical extension of four investing paradigms: three-dimensional equity market segmentation; qualitative manager assessment; static performance attribution; and mean-variance optimization.

Net assets reflect investor preferences, recent sector performance, and the distinctive features and pricing of the Dow Jones and Standard & Poor's sector ETFs.  When comparing pairs of sector ETFs, our research showed that the Dow Jones sector ETFs were ahead in five categories, while S&P's led in four categories.

Equity sector investing, when implemented correctly, can result in potential outperformance.  However, the Margrabe Outperformance Option Model reveals that sector ETFs vary widely with respect to their opportunity and risk, relative to large-cap core and style indices.

Sector investing is a natural complement to traditional stock-picking, offering the potential to add value while controlling exposure to non-systematic risk.  Equity sector investing will, I believe, continue to grow over the next five years, andkey participants in the investing arena will determine the growth of sector investing.  However, key participants in this arena must take a variety of steps to fully realize the potential of this strategy.

Introduction

Shoppers love competition.  Competition means more outlets, a wider selection, lower prices and, in some instances, more knowledgeable and attentive customer service representatives.  Why should the exchange-traded sector fund marketplace be any different?  Underscoring the increased competition on this space, Harry Seneker of Dow Jones Indexes has written an important article, "Comparing Apples: Sector Indexes Are Not All the Same," that advances sector fund investing.

The exchange-traded sector fund domain in the United States is comprised of funds designed or sponsored by multiple organizations, including: Cohen & Steers, Dow Jones, Goldman Sachs, Merrill Lynch (HOLDRS), Morgan Stanley, Nasdaq, Standard & Poor's, and Wilshire Associates.

In this article I will focus on two existing sets of sector funds - the 12-fund Dow Jones U.S. sector fund family and the 9-fund Select Sector SPDRS series - because they represent two different holistic approaches to the U.S.U.S. equity market sectors.  I will address the following major issues:

  1. How does equity sector investing fit into the broad context of investing?
  2. What investment paradigms provide a conceptual basis for equity sector investing?
  3. What is the current size and distribution of exchange-traded sector funds?
  4. What do investors want from sector ETFs?  What general framework enables investors to compare sector them?
  5. How have sector ETFs performed in 2003?
  6. Is equity sector investing worth it?
  7. What is the potential for sector plus individual securities investing?
  8. What steps need to be taken for sector fund investing to grow?

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