From the September 2006 issue of Research Magazine • Subscribe!

Watching the S and P Striptease

As one of the most closely watched stock market benchmarks in the world, the S&P 500 is a lot more complicated under the surface than it may initially appear. More than just a list of 500 big stocks, when it's stripped to its bones, the S&P is actually a complicated system of nine key industry sectors, each with its own behavior and potential ups and downs And undressing the S&P to this naked state is actually fairly simple -- you need look no further than the Select Sector SPDRs, which track each sector in isolation from the rest.

Out of these nine gauges of industry performance, only three -- the Financials (XLF), Health Care (XLV) and Technology (XLK) groups -- account for over half of the S&P's total sector weighting. As each sector peaks or wanes, S&P industry weightings are affected accordingly. For example, in March 2000, technology accounted for nearly 40 percent of the entire S&P 500, thanks in large part to explosive performance of Internet and telecommunications companies. However, shortly thereafter, technology stocks suffered profound losses and have since remained laggards compared to the rest of the market. Today, technology now accounts for just 17.62 percent of the S&P 500. Even so, despite being the only S&P sector to post a negative return over the past five years, technology still remains a crucial component within the overall index.

In terms of pure numbers, no other sector has more stocks (89). Microsoft, International Business Machines and Cisco Systems round out the top three holdings, with newcomer Google narrowly making the cut into the Top 10. Like all of the Select Sector SPDRs, companies with the largest market capitalizations have the greatest influence on overall performance. Included in the Technology SPDR are 13 telecommunication stocks, with AT&T and Verizon Communications being the largest.

Compared to these household names, the Materials SPDR (XLB) has gone relatively overlooked. Despite its low sector representation in the S&P 500, (only 3.01 percent), XLB has delivered a hard-to-miss return of 8.36 percent over the last five years. Only the Energy SPDR (XLE) has had better performance over the same time period. Companies within the materials index are focused around industries such as chemicals, construction materials, containers and packaging, metals, mining, paper and forest products. Among its largest components are E.I. DuPont de Nemours & Co., Dow Chemical Co. and Alcoa Inc.

In case you've just come out of hibernation, the energy sector has been soaring in accord with fuel prices, and the energy components of the S&P 500 have enjoyed spectacular returns. Over the past five years, XLE has been the single best-performing industry sector and the only one that can brag double-digit gains. Most of the 30 companies within the Energy SPDR are involved in producing, drilling or distributing petroleum products. Top holdings include ExxonMobil Corp., ChevronTexaco Corp and ConocoPhillips.

Can energy maintain its recent performance edge? Michael Krause, president of AltaVista Independent Research, thinks so. His New York-based firm has given the Energy SPDR its highest grade, called the "ALTER" (AltaVista Long-Term Annual Return) score, which calculates a sector's rankings based upon the likely performance return of money invested in the business at today's prices. Given earnings estimates for the remainder of 2006, Krause notes that energy has a P/E ratio of only 10.2, making it actually the least richly valued of all nine S&P 500 sectors -- even after the sector's recent run-up. According to AltaVista's research, the S&P 500 by comparison has an overall P/E of 14.8.

Got Trading Volume?

Dan Dolan, director of wealth management at the Select Sector SPDRs, isn't surprised by the success of these ETFs. During the first half of 2006, total assets in all of the funds grew by 23 percent to $16.24 billion. Furthermore, Dolan points out the Select SPDRs represent more than 90 percent of sector-based ETF trading volume.

In fact, the volume numbers are so big they often dwarf the trading activity of blue chip stocks. For example, the three-month trading volume average through June 30 was 6.2 million shares a day for International Business Machines. Boeing's daily turnover was around 4.1 million shares and American Express traded around 5 million shares a day. During the same period, average trading volume of the Energy Select Sector SPDR amounted to 26.1 million shares a day; 8.6 million shares of the Financial SPDR changed hands every day. In extreme market conditions, trading volume figures have the tendency of becoming even more exaggerated. For example, on June 8, the XLE traded a staggering 75.3 million shares. By comparison, during the same trading day, industry behemoths Exxon Mobil Corp and Chevron Corp. traded just over 33 million and 15.2 million shares, respectively.

While providing increased liquidity, investing in the Select Sector SPDRs also avoids many of the risks associated with owning individual companies. Aside from total bankruptcy because of mismanagement or corporate malfeasance, individual companies face competitive risks, earnings risk and a legion of other business risks. From the perspective of an investor, it's difficult to quantify all of these risks and the host of unknowns. Michael Iachini, senior research analyst at the Schwab Center for Investment Research, says, "By investing in a sector ETF, you can get exposure to a broad sampling of companies in the sector without worrying about company-specific factors." In other words, stocks can go out of business, but sectors never die.

Funds or Etfs?

Many advisors, tired of getting socked with minimum holding periods and redemption charges for early withdrawals, have completely switched to sector ETFs. Unlike traditional funds, ETFs have no holding period redemption charges and can be traded as long as the markets are open. Toss in the flexibility to trade underlying call and put options (which traditional sector funds lack) and sector ETFs emerge as a very serious threat.

Since the Select Sector SPDRs passively shadow the performance of their underlying sectors, this translates into lower portfolio turnover versus the typical actively managed sector mutual fund. Less churn means greater tax efficiency plus lower transaction costs.

Another metric to watch is, as always, the expense ratio. While expenses aren't the only cost factor, they are arguably the most important. According to Morningstar data, the average sector mutual fund had a 1.70 percent expense ratio as of mid-2006. In December of 1998, when the Select Sector SPDRs were first introduced, those ETFs carried a 0.65 percent expense ratio, and as time has passed and assets have grown, the SPDRs have passed on the economies of scale to their shareholders by lowering expenses. Currently, all of the funds carry ratios of just 24 or 25 basis points, which naturally compares favorably to competing ETFs. The expense ratio category average for all 88 sector ETFs as of mid-July was 0.44 percent, according to ETFguide.com.

Make the Odds Work for You

Beating individual sectors with actively managed mutual funds is clearly not a cinch. Over the past five years, Standard & Poor's research observes that a whopping 75.74 percent of information technology mutual funds underperformed the S&P Information Technology index. In other categories, underperformance wasn't as bad, but was still difficult to ignore. For example, the S&P health care sector outperformed 51.02 percent of actively managed health care mutual funds, while the telecommunications sector beat an even 56 percent of corresponding funds.

Historical results like these don't exactly instill a lot of confidence in the ability of active mutual fund managers to deliver sector-beating returns. As a result, more advisors are coming to the conclusion that it's better to trust the indexes than to bet on the portfolio managers that try to outperform them and fail.

The S&P stripped down to its naked state is an attractive proposition. Over the past five years, seven of the nine Select SPDRs outperformed the S&P 500. In retrospect, it's always easy to separate the winner sectors from the losers, but for those who can overweight the right sectors and underweight the wrong, beating the broader indexes is possible.

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