Who Else Wants Ex-Sector ETFs?

by on April 12, 2010 | ETFs Mentioned:

The ETF industry continues to demonstrate impressive growth, both in assets and number of products. Already in 2010 more than 60 new ETFs have hit the market, putting this year on pace to shatter last year’s product development record. This surge in product offerings has led some to lament that the industry has reached (or even blown past) a saturation point, pointing to the increasingly granular and esoteric funds that have popped up in recent years. Some degree of contraction in the ETF industry in 2010 is likely–in fact it’s begun already–but there are still a lot of good ideas coming out of ETF issuers. The VIX ETNs from iPath are a great example (they have aggregate assets of more than $1.5 billion), as are several of the ETFs to launch over the last year (see the Most Successful New ETFs of 2009).

And there are still some interesting stones that remain unturned. No one has brought to market an automotive ETF, one of the several glaring opportunities we see in the current ETF lineup. Several of the world’s largest and most unique economies aren’t covered by U.S.-listed ETFs, and there seem to be opportunities for improvement on other popular funds as well.

There is no shortage of ideas under consideration–there are more than 500 ETFs in registration–but it never hurts to have a few more ideas out there. So here’s another: a line of “ex-sector” ETFs.

Inspired By The Islamic ETF

When analyzing the performance of the various faith-based ETFs during the first quarter of 2010, one outlier immediately jumps out. The gains delivered by the FaithShares products (based on indexes constructed in compliance with Christian, Baptist, Catholic, Lutheran, and Methodist values) were all fairly consistent (and all better than SPY), while the Dow Jones Islamic Market International Index Fund (JVS) lagged about 500 basis points behind. That’s a significant single-period gap, but there’s a relatively simple explanation.

JVS is based on the Dow Jones Islamic Market International Titans 100 Index, a benchmark that consists of stocks that meet Islamic principles. According to the fund’s Web site (emphasis added), “excluded businesses include alcohol, conventional financial services (banking, insurance, etc.), casinos and gambling, pornography, tobacco manufacturers, pork related products and weapons companies.” So the explanation for the relatively poor performance becomes clear; financials surged in the first quarter of the year, but JVS, which is effectively an ex-financials ETF, missed out on this bump.

So here’s the step-by-step instructions for a new ETFs (actually for nine of them):

  1. Start with SPY
  2. Remove all of the financial stocks
  3. Repeat for energy, technology, consumer discretionaries and staples, utilities, materials, and industrials

The result is a line of “ex-sector ETFs” that offer diversified exposure to the U.S. economy with the exception of one particular sector. It would be an easy way to underweight a particular sector while retaining balanced exposure to the rest of the market.

Sector ETF Performance*
Ticker Sector Performance
XLK Technology 4.2%
XLE Energy -16.5%
XLY Discretionary 7.9%
XLF Financial -23.1%
XLB Materials -12.5%
XLV Health Care 1.3%
XLU Utilities -14.8%
XLP Staples 1.9%
XLI Industrials -8.3%
From 9/1/2008 to 3/31/2010

While there would obviously be significant overlap between these products, there is also a strong likelihood of each maintaining a unique risk/return profile. In recent years a lot has been made of diversification letting investors down when they needed it most. While correlations between global markets has become undeniably stronger, returns across various sectors of the U.S. economy have been all over the board.

Between September 2008 and the end of the first quarter of 2010, the gap between the top performing sector SPDR (XLK) and the worst performing (XLF) was nearly 30%. Moreover, five of the nine sector funds were in the red during this time while four were in positive territory.

The same process could be applied as a spinoff of the recently-launched small cap sector ETFs from PowerShares, essentially replacing the S&P 500 with the S&P SmallCap 600. Do the same for the MidCap 400, and we’re up to almost 30 new ETF products. Repeating the process on the MSCI Emerging Markets Index or MSCI EAFE Index (or any number of global benchmarks) could spawn dozens of additional ETFs. The permutations of this concept (e.g., an “ex-Financials and Materials ETF”) could become nearly endless.

Disclosure: No positions at time of writing.