The Changing Face Of Sector ETFs

[This article appears in our May issue of ETF Report.]

Exchange-traded funds that exclude some sectors and funds that use smart-beta factors are part of several new and notable sector-related ETF launches. Unique takes on the sector space are often few and far between—2014 saw only a scattered handful—but over the past year or so, there has been what seems like a burst of such funds.

Last year, ProShares released several S&P 500 ETFs that exclude single sectors—such as ex-financials—in September, while John Hancock teamed up with Dimensional Advisors to launch four smart-beta sector funds at around the same time, followed by another five in March 2016.

Another heavy-hitter name, State Street Global Advisors, also launched two new Select SPDR ETFs, the Financial Services Select Sector SPDR (XLFS) and the Real Estate Select Sector SPDR (XLRE), which divide its popular Financial Select Sector SPDR (XLF | A-92).

Plus, there are a handful of stand-alone ETFs focused on certain industries like utilities and health care.

Despite having some unique strategies or compelling themes, according to some industry watchers, many of these new sector-related ETFs are having difficulty attracting assets. Granted, new funds may get off to a sluggish start, and 2015 saw a near-record number of launches, which may have led to more competition. A volatile stock market may also have had an impact.

“Generally, when market conditions are positive, you’ll see more sector-type products, because people are more interested in digging in. When market conditions are worse, it’s harder to launch those products, because people are less likely to get out of core exposure,” said Christian Magoon, chief executive officer of Amplify Investments.

ProShares S&P Ex-Sector Funds

Of the new sector-based releases, Magoon and Paul Britt, senior analyst at FactSet, said the ProShares S&P 500 sector funds omitting certain sectors seem to be the most unique. The four funds—S&P 500 Ex-Energy (SPXE), the S&P 500 Ex-Financials (SPXN), the S&P 500 Ex-Health Care (SPXV) and the S&P 500 Ex-Technology (SPXT)—offer core exposure to the broader market, except for certain sectors.

“I’m a fan, with respect to the structure. They make sense,” Britt said.

He added these funds could benefit investors with a large exposure to certain sectors because they work in a particular industry and may already have a lot of company stock.

Magoon said he’s “really intrigued” by these ETFs.

“To be able to invest in the S&P and eliminate that energy sector is really appealing, based on where that sector is and the outlook for it, even if it’s just to eliminate the uncertainty,” he added.

He sees these as a way to hedge or express an opinion on a market segment, especially since big moves in the S&P 500 often are caused by individual sectors. These ETFs give advisors the opportunity to avoid more volatile sectors without having to create separate trades, like shorting options.

However, these funds haven’t seen a great deal of interest yet, despite the good concept, which is surprising, Britt says.

“Maybe the problem for traders is this is the basket that they aren’t trading. So if we think about traders driving the shorter-term-type stuff, and driving a lot of the order flow, then this basket is by definition not trading,” he noted.

John Hancock Multifactor ETFs

John Hancock joined with Dimensional Funds to create a full suite of smart-beta sector ETFs, rolling out its Multifactor Consumer Discretionary ETF (JHMC), its Multifactor Financials ETF (JHMF), its Multifactor Technology ETF (JHMT) and its Multifactor Healthcare ETF (JHMH) in September 2015. Those ETFs were followed by another five, covering consumer staples, energy, industrials, materials and utilities in the first quarter of 2016. They were the first multifactor sector ETFs.

Magoon said John Hancock’s using Dimensional Funds’ expertise in the smart-beta filing was a canny move, but he wonders how much advisor interest there is for another smart-beta product, since it’s an already-crowded field. He also wonders if John Hancock knows how to distribute ETFs, and if the Hancock and Dimensional brands will translate to the ETF business.

Michael Krause, president of AltaVista Research, said he likes smart-beta products overall, and prefers the multifactor funds—like these John Hancock offerings—over single-factor products. The funds offer a “fair amount of original investments,” he said, but he also thinks they might be a bit expensive. The sector funds have an expense ratio of 0.50% each.

Select SDPR ETFs

In August, the Global Industry Classification Standard will elevate real estate as its own separate sector, and the XLFS and XLRE ETFs represent that new classification, Krause says. The main XLF fund will continue to trade as is, he adds.

Britt says the XLFS could be a useful fund, especially for advisors whose clients already have real estate exposure of some kind.

Krause concurs: “Both XLFS and XLRE appear to represent attractive long-term value to us. But different stages of the economic cycle are likely to affect each differently. Now Sector SPDR investors have ready-made vehicles to invest accordingly.”

These two funds have also been slow to catch on, but Krause says that may chance come in August, when the new classification comes online.

Volatility in the financial sector may be holding back XLFS, but traders may be cautious, too.

“Funds like XLF are so huge and well-established that folks have seen a lot of wannabes come and go. Active traders say, ‘Unless you get some liquidity, I’m just not interested at all,’” Britt said.

Sector Rotation ETFs

One new fund that’s gaining attention is the strategic beta ETF PowerShares DWA Tactical Sector Rotation ETF (DWTR). Britt calls it PowerShares’ answer to the $3.4 billion First Trust Dorsey Wright Focus 5 ETF (FV | B-41). The difference with DWTR is that fund can rotate into cash, something a number of new funds are including, he says.

The Dorsey Wright brand may also be a powerful draw for the fund, and Robert Goldsborough, analyst at Morningstar, said that may be why it’s attracted more assets than other new sector releases.

“I’m a fan of Dorsey Wright, and I think in general the fund has a much brighter future than most of the other [recent releases],” he said.

However, after DWTR launched, First Trust followed up on FV in March with a very similar fund that also has a cash component. The First Trust Dorsey Wright Dynamic Focus 5 ETF (FVC) uses almost the same methodology as FV, but it can rotate up to 95% of its weight into cash. It’s still early days for FVC, but it will be going head to head with DWTR.

Stand-Alone ETFs

Goldsborough said the Reaves Utilities ETF (UTES | D-76) is also interesting, because it’s a little bit different. There aren’t very many utilities ETFs available, and Goldsborough says this ETF is truly an actively managed ETF. The timing makes sense, too, given the sector’s strength, he notes. The fund’s downside is that utilities are such a small slice of the S&P 500.

“It’s not clear to me that any actively managed sector ETFs will do well, but if anyone would, I’m not sure it would be utilities; it might be health care or technology,” he said.

This ETF also hasn’t gathered much in assets, despite utilities being a positive sector in 2016, he says.

The lack of assets for most of these new launches may not necessarily be an issue with a weak market, but it may be more of a problem of a crowded field, Goldsborough notes. Two new health sector releases—the Loncar Cancer Immunotherapy ETF (CNCR) and the Market Vectors Generic Drugs ETF (GNRX)—are examples.

“I do think we’re starting to reach a point where ‘too narrow’ seldom seems to work, even in ETF land. I think Market Vectors is slicing it a little narrow with the generic drug ETFs, and Loncar has the same problem. They’re interesting ideas with compelling investment cases and nobody comes,” he said.