So Many Choices!

It’s easy to become giddy with the growing number of exchange-traded funds (ETFs) and all the investment opportunities that they offer.

Nevertheless, a new obstacle has been created for financial advisors with all of these ETF choices: It takes more time to sort through the maze of options.

Simply put, sifting through and choosing the appropriate funds has become a laborious task.

“The growing number of sector funds means spending longer amounts of time on investment research,” notes Judd Carlton, CFP, with Glassner Carlton Financial in Cedar Knolls, N.J. “If we decide to buy an energy sector ETF we have to ask ourselves whether we want to equal-weight the underlying stocks or whether we want to include energy companies domiciled abroad.”

Nowhere are all of these choices more apparent than with industry sector ETFs.

According to a recent report published by State Street Global Advisors, there’s $61.9 billion invested in sector ETFs, which represents roughly 10 percent of all ETF assets.

In 2005, there were just under 75 sector ETFs. Today, there are almost 200 sector funds. How can you select the right funds for your clients from the myriad of choices?

Know the SceneIt’s important for advisors to understand the ETF market isn’t just a collection of sector funds, but a conglomeration of funds with different index strategies.

Some of the earliest sector ETFs like the iShares Dow Jones U.S. sector funds and Select Sector SPDRs, which were unveiled in 2000 and 1998 respectively, are designed to follow true market barometers. This means the underlying indexes they track are selecting stocks passively and weighting them by market capitalization. ETFs that follow this formula are not trying to beat the market because they are the market.

Around 2006, a new generation of sector ETFs began showing up. It was then that InvescoPowerShares, Rydex Investments and a host of other fund providers began offering a new class of industry sector ETFs, ones that attempt to outperform index ETFs based upon true market barometers. The way they would do this was by using alternative methods for selecting and weighting stocks.

A Lesson in DivergenceIt’s interesting to observe that many ETFs following the same industry sector may own the same exact stocks, but be posting different performance results (see Figure 1). Most ETFs that track a broad basket of technology sectors include Microsoft, Cisco Systems, Dell Computer, IBM and Oracle among major holdings. However, technology ETFs that may own these same stocks don’t all share the same performance, volatility or level of risk.

How is it possible for ETFs that all follow the same exact industry sector to have diverging performance results? The answer can be found by examining what each of the underlying indexes for these ETFs is doing.

The iShares Dow Jones U.S. Technology ETF (IYW), Technology Select Sector SPDRs (XLK) and the Vanguard Information Technology ETF (VGT) all follow market indexes that select technology stocks passively and weight them by market cap. Even though each of these funds is following a different index with a different number of holdings, they all share a common goal of attempting to represent a market of technology stocks. Remember, they aren’t trying to beat a market of technology stocks, because they are the market.

In contrast, the PowerShares Dynamic Technology Sector Portfolio Fund (PTF) and the Rydex S&P Equal Weight Technology ETF (RYT) are using indexes that follow investment strategies, not market indexes. Why would an ETF like PTF decide to select stocks with quantitative filters? And why would it decide to weight those stocks equally? In other words, why would PTF use a methodology completely different than traditional methods, which select stocks passively and weight them by market cap? Same thing goes for RYT. Why would it decide to equally weight each of the S&P’s technology components?

The answer is simple: These funds aren’t trying to match a market of technology stocks; they’re trying to outperform it.

What do your clients want to own? Do they want technology ETFs that represent the market or ones attempting to beat it? If the sector ETFs you choose for your clients are heading in one direction, but the market sectors you thought they were tracking are heading in another, you better have some good answers. If you don’t understand what’s going on inside sector ETFs, how can your clients?

Barclays Global InvestorsBGI offers 23 funds based upon Dow Jones U.S. industry sectors. Stock holdings are passively selected and then weighted by their float-adjusted market capitalization. The composition of the indexes is reviewed quarterly. These particular iShares sector funds attempt to mirror market sectors, not outperform them.

InvescoPowerSharesEach of the 26 Dynamic Sector Portfolios offered by InvescoPowerShares follows indexes based upon investment strategies, not market benchmarks.

For example, the PowerShares Dynamic Technology Sector Portfolio Fund (PTF) attempts to identify the best stocks within the technology sector. Each quarter, 60 stocks are selected from a custom technology universe created using proprietary research. After companies are selected they are assigned a modified equal dollar weight inside the index.

Other PowerShares funds that follow Dynamic Intellidex indexes use a similar investment approach. While the weighting methodology of the stocks is relatively straightforward, the precise formula for stock selection is never fully disclosed. This sort of missing transparency doesn’t occur with ETFs based upon true market indexes.

Merrill Lynch HOLDRs Each of the HOLDRs is a predefined collection of stocks in a particular industry sector. As stocks within a HOLDRs trust merge or disappear, they aren’t replaced or rebalanced. As a result, HOLDRs have the tendency to become concentrated in the remaining stock holdings.

Unlike traditional ETFs, owing HOLDRs is awkward since they can only be purchased in 100-share or round lot increments. If a client wants to buy, say 50 or 75 shares of a HOLDR, he can’t. Also, instead of charging an annual expense ratio, HOLDRs charge a $2 quarterly fee for every 100 shares owned.

The fact that HOLDRs don’t follow any particular index and aren’t managed raises questions about their usefulness as accurate barometers of industry sectors.