What To Know About Sector ETF Investing

On Nov. 20, S&P and MSCI announced dramatic changes to its Global Industry Classification Standard (GICS), which underpins the indexes of hundreds of sector ETFs.

The changes include the introduction of a new communications services sector, built on top of the existing telecommunication services sector, and the probable reclassification of some of the most-well-known tech and media stocks, such as the FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks.

To make sense of the developments, ETF.com recently spoke with Denise Chisholm, a sector strategist for Fidelity Investments, whose specialty is the use of historical probability analysis to tease fact from fiction in how sectors work.

ETF.com: The GICS revisions going into effect next year are huge. The changes could potentially impact the lineup of dozens of ETFs, including those from Fidelity. What steps should investors take now to prepare?
Denise Chisholm: As a sector investor, there are two things you're concerned about. First is the availability of the specific exposure you're looking for—meaning, if you want energy exposure, you don't want an ETF with both energy and utilities in it. Second is understanding how that exposure behaves. In the new GICS structure, [S&P and MSCI] did a great job of thinking about how investors want their exposure, by putting all the communication exposures in one basket. But investors really need to be aware that they also created a fair amount of diversification in that new GIC; specifically, in burying telecom services. Telecom services behave very differently from media companies, but now they're in the same GIC.

ETF.com: How do they behave differently?

Chisholm: Let me give you a real-world example. During 2015 and 2016, by many measures, profits actually contracted. We had a profits recession without an economic recession. What you saw then, and what you've seen in history whenever that happens, was a defensive rotation.

So, in that defensive rotation, you'd equal-weight defensive sectors, like consumer staples, utilities, health care and telecom services. After all, historically, people still need to buy toothpaste and turn on the lights; they still need to go to the doctor—and they still pay their cable bill.

So from 2015 to June 2016, the S&P was down, modestly. Telecom services and cable companies—companies in that defensive basket—were up about 8%. Media, though, was down. It underperformed the S&P by about 400 basis points.

So if you're an investor who's worried about another profit contraction and you want this good defensive exposure, it's now buried deep in this new GIC. That’s something people need to be aware of.

ETF.com: So should investors think of the new communications services sector as a cyclical play instead of a defensive one? Is it neither?

Chisholm: The new communications GIC is dominated by cyclical exposures. The classic telecom services—diversified telecom, wireless, cable—is a small portion in this broader cyclical exposure. So the sector will act more cyclical.

We'll see if there remains the availability of defensive telecom services as a stand-alone exposure. But for investors worried about another profit contraction, they may be left now with only three options: consumer staples, utilities and health care.

ETF.com: Over this market rally, the tech sector—particularly, a few specific tech stocks—have increasingly driven S&P 500 returns. Is the S&P 500 Index effectively becoming a de facto tech sector play?

Chisholm: I hear that a lot, both internally with our diversified portfolio managers and externally from clients: "Tech is the only one working; 50% of the gains come from the top 10 stocks, which are all tech," and so on. But I do historic probability analysis, so I look at things a little bit differently.

If you look at the relative performance of tech versus the market, or versus the worst sector, or versus average sector performance, you plot that outperformance over time. You'll find we are dead center of the range. It’s true that a lot of gains have come from tech, but it's not really different from what we've seen in history. We're not experiencing any tail event here.

Up until the last three months, we saw very modest returns in the S&P 500. And the more modest returns you have, the more it's just a function of math that you see the 50% of gains accounted for by 10-12 stocks. That's very typical, when I judge through a historical lens.

We know that we get narrower, from a sector perspective, when the leading economic indicators decelerate or deteriorate. As the economy gets worse, fewer and fewer sectors actually work. As the economy gets better, more and more sectors work. And right now? We're dead-on average for where are in the cycle.

As we enter 2018, if we expect economic conditions to get better—and I do—then we [should] expect the market will get broader. So, yes, it's true that in 2017 tech dominated, but I think that’ll broaden out. That said, I think technology has a good chance to be a consistent leader into 2018.

ETF.com: What other themes are you keeping an eye on for 2018?

Chisholm: I think the key theme is corporate profits.

In 2015 and 2016, you saw a lot of investors be very cautious. A lot of people talked about lower interest rates, and how that caused high-dividend-yielding stocks, utilities and consumer staples to outperform. But what I saw was a consistent profit contraction without an economic contraction, one that was met by a typical defensive rotation. And corporate profits are what are going to get us out of that.

What you've seen is, in fits and starts from October of last year, a typical rally. Going into next year, I think the question is, can that continue?

Based on the historical analysis I’ve done, I think it can. Average profit recoveries tend to last four years. And if our starting point is the low of the contraction, we could be early on in a durable profit recovery—meaning, thematically, you'll want to skew away from the defensive sectors of consumer staples, utilities, health care and telecom; and [skew] more toward cyclically oriented sectors, like technology, financials, industrials and consumer discretionary.

ETF.com: Recently, iShares launched a new active sector ETF suite that uses artificial intelligence and computer algorithms, which is the most experimental thing we've seen out of the sector space in a while. From your perspective, what room is left to innovate in sector investing?

Chisholm: Sectors are unique; I'd almost call them a unique asset class among equities. It's one of the few ways you can divide up the market and declare exposures—I'm not sure factor [investing] does it, and I'm not sure value and growth [investing] get at it, either.

Innovation is in how you use the building blocks, not what’s in the building blocks. Sectors have great utility at potentially providing solutions. If you're an RIA or an institution looking to mitigate your downside potential, you could buy a low-vol ETF; but another way to do that would be through equal-weighted exposure of defensive sectors. Or, if you believe in the profit recovery, you could buy a high-beta ETF, or you could tilt to cyclical sectors.

From an innovation perspective, we've done a lot, in terms of getting the building blocks already out there. Now we have to turn those building blocks into one of two things: alpha production or solutions to the client. Those are the next steps.

ETF.com: What’s the one thing you wish investors understood better about sector investing?

Chisholm: One dynamic I've felt has been misunderstood is diversification. Sectors are so much more diversified than stocks, and the more diverse your exposure, the more you need to increase your bet size to potentially get the same alpha you'd get if you bet on stocks.

If you're talking about 200 or 300 basis points overweight in a cyclical sector like industrials, that's not going to provide the same potential for alpha as if you owned Deere, Cat and 3M.

You have to be aware of diversification and be comfortable ratcheting up that bet size. Mathematically, it's the same risk/reward, but you have to know that going in.

Contact Lara Crigger at [email protected]