ETF Trends
ETF Trends

In a recent blog post, I discussed how investors can potentially improve their core equity exposure—in terms of diversification and the potential for generating alpha—by implementing sector investing.

We have seen investors increasingly use Industry ETFs in addition to sectors to gain more targeted exposure and amplify the drivers of sector growth. But it’s important to evaluate Industry ETFs with a close eye. Two indices tracking the same industry can look alike at first glance, but different approaches to index construction can result in material deviation in how the index is composed and, ultimately, performs over time.

The SPDR® ETF Industry lineup follows the S&P® Select Industry Indices, which use a modified equal weighting approach. By applying an equal weight to each stock in the index, the underlying exposure reduces stock-specific risk and provides deeper market cap segmentation to large-, mid-, and small-cap firms.

Other popular industry indices use the more traditional market capitalization-weighted methodology. But market cap-weighted indices have the potential to increase portfolio concentration when targeting a narrow market segment like sector sub-industries.

To understand how differences in methodologies can give rise to markedly different exposures, let’s compare two seemingly similar ETFs that track the Biotechnology Industry: SPDR® S&P Biotech ETF [XBI] and iShares Nasdaq Biotechnology ETF [IBB].

While the index that IBB tracks weights constituents by market cap, XBI uses a methodology where all stocks are equal-weighted. Historically, this has demonstrated four potential benefits:

1. Lower concentration and less skew in risk toward top index holdings

Weighting constituents by market cap can translate to high concentrations in an ETF’s largest securities. As illustrated by the “Concentration Analysis” graph below, though IBB has more securities, its Top 10 holdings make up 58% of the portfolio (versus only 11% for XBI).1 As a result, IBB’s risk is skewed toward the concentration in Top 10 holdings.

Source: State Street Global Advisors, Bloomberg, as of 6/30/2015.

The lower stock-specific risk for XBI can allow the broader industry to drive returns, as opposed to a handful of particular stocks.

2. Deeper market cap segmentation offers broader industry coverage

As market cap-weighted indices assign the largest weights to those securities with the greatest market values, it stands to reason that these indices would exhibit an inherent large-cap bias. The “Market Cap Segmentation” chart demonstrates that this is the case when comparing XBI and IBB. While 21% of IBB’s holdings are mid- and small-cap securities, 80% of XBI’s securities are mid- and small-cap.2

Source: State Street Global Advisors, Bloomberg, as of 6/30/2015.

With a broader representation across market capitalizations, XBI can offer greater diversification and deeper market breadth to the entire industry within the US market.

3. A potentially better complement to the broader sector

An equal-weighted Industry ETF like XBI can also be a solution for investors looking to tilt broader sector exposures toward sub-industries with greater potential for growth. As depicted in the “Overlap to XLV Health Care Select Sector SPDR Fund” chart, a comparison between the Health Care Select Sector SPDR Fund [XLV] and IBB holdings reveals that IBB has a 53% overlap with XLV, while XBI and XLV only have a 7% overlap.

Source: State Street Global Advisors, Bloomberg, as of 6/30/2015.

By offering exposure to numerous securities not in the broader sector index, XBI has the potential to efficiently amplify the larger sector position toward the more growth-oriented Biotech Industry.

4. Potential to harness thematic industry trends

We’ve discussed the strategic benefits of equal-weighted indices, and they have tactical benefits as well. For instance, as a result of deeper market cap segmentation and industry breadth, XBI has been able to better capture a prevalent trend within Biotech: mergers and acquisitions. XBI, relative to IBB, has overweighted M&A targets in most of the top deals over the last 18 months. In fact, XBI has been overweight in 11 out of the top 12 deals, while IBB did not hold a position in 2 of those deals.3

Source: State Street Global Advisors, Bloomberg, 9/30/2015.

The data displayed in the “US Biotechnology M&A Deal Volume” graph underscores the importance of choosing the right index—and the ETF that tracks it—when seeking to capture the growth of an industry like Biotech.

So, what’s the big takeaway for investors?

Methodology is always worth a closer look as certain approaches may not offer the exposure you seek.

For investors transitioning to a more tactical investment management approach using Industry ETFs, it’s important to remember that understanding the differences among indices can help achieve the most precise exposure. The bottom line is that there is no perfect index, but investors would be well suited to understand how the chosen index is constructed and what exposures or hidden biases may exist before investing.

To learn more about sector rotation and the potential benefits sectors pose over traditional style investing, read my first post in this series, Get More from Your Core: Why Sector Investing [Sector Investing Series, Part 1].

Definitions

S&P Select Industry Indices
The S&P Select Industry Indices are designed to measure the performance of narrower GICS industries within broader sectors and are based on the S&P Total Market Index, which has approximately 3,800 constituents. These industry indices are equal-weighted, which reduces stock specific risk and provides deeper market cap segmentation to large-, mid-, and small-cap firms.

Market Cap-weighted Indices
A type of market index whose individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. The value of a capitalization-weighted index can be computed by adding up the collective market capitalizations of its members and dividing it by the number of securities in the index.

1State Street Global Advisors, Bloomberg, as of 6/30/2015
2State Street Global Advisors, Bloomberg, as of 6/30/2015
3State Street Global Advisors, Bloomberg, as of 6/30/2015