Cyber security and the risks of following fashion

ETF Securities launched ETF ISE Cyber Securities GO UCITS ETF (ISPY), the first European-listed ETF to offer exposure to the cyber security sector, in September following the popularity of US-listed PureFunds ISE Cyber Security ETF. Known by its code HACK, the US-listed ETF was launched in December 2014 and fortuitously started trading just 12 days before the Sony Pictures data breach. It gathered more than $1bn in assets in its first year of trading, and its share price skyrocketed above technology ETFs.

The argument for ISPY sounds compelling, founded as it is on the growing role cyber security threats play in the corporate world.

However, Alan Miller, founder of SCM Direct, says: "The danger of some of these new, very targeted ETFs is that they become really specialised - you get a fad and a small number of very overpriced stocks and then someone comes along and structures an ETF to invest in those and everyone loses a lot of money."

There is a big difference between investing in a cyclical sector and in a fashionable sector, which may well have fewer constituents and be a more concentrated bet pumped up with higher valuations. Look, for example, at the contrast between a financial sector ETF and ISPY. "A financials ETF will be well diversified across different types of financial company and across regions," says Mr Miller.

The MSCI World Financials index, tracked by db x-trackers MSCI World Financials Index UCITS ETF 1C (XWFD), has 355 constituents, spread across six countries and seven industries. By contrast, cyber security ETF ISPY has exposure to just 33 constituents, which are predominantly listed in the US and 69 per cent denominated in the US dollar. ISPY's largest allocation is to a young Californian data security company that is smaller than the smallest S&P 500 company.

Mr Miller says: "SCM Direct found that 18 per cent of the companies in ISPY were forecast to make losses next year and the average valuation of the remainder was 44 times next year's earnings. These are very high multiples that pose risks to investors should such companies fall out of fashion.

"Some broad sectors like technology or pharmaceuticals will often suit a more diversified index approach to reduce individual company risk. The more specialised sectors can often be highly concentrated and highly volatile and may actually better suit individual stock picking in such circumstances."

Caroline Shaw, head of fund and asset management at Courtiers, says: "There is nothing wrong with the ISPY product, but you have to know what it involves. Generally, the company size is very small so you've got a mid- to small-cap bias and the currency exposure is a risk. But I also have a concern about the fact that some of the securities on its list are well-known names such as Cisco Systems (US:CSCO).

"That is the 38th largest company in the S&P 500 and I wouldn't have immediately thought of that as cyber security. Lots of people will already hold Cisco Systems through their US equity exposure, so you could be doubling up on exposures without realising.”

The cyber security index is created by taking the 200 stocks in the world with a presence in cyber security and narrowing that down based on revenue and exposure. They are then sifted into two categories - infrastructure providers and services - and given a weighting in the index. Christian Magoon, consultant to ISE ETF Ventures, said at the time of launch: "There is a risk in buying just one or two companies in the sector because their technology could be leapfrogged, but one company's loss will be another's gain."

The provider says that the ETF is designed to work as a complement to existing technology holdings and said there is less than a 10 per cent portfolio overlap with the tech-heavy Nasdaq 100.

Why cyclical sectors are a different story

In contrast to cyber security stand more familiar sectors such as industrials, financials, telecoms, utilities, technology and biotechnology. Many of these are cyclical and come in and out of fashion in more predictable waves than new sectors that become suddenly popular. Betting on a cyclical sector could form part of a targeted play on a macro economic or political trend such as rising interest rates or an injection of QE.

Adam Laird, passive investment manager at Hargreaves Lansdown, says: "There is justification for using sector ETFs. Looking ahead, rate rises are the big topic. Different sectors react differently to rate changes.

"Utilities have high levels of debt so tend to perform badly in the case of a rate rise. However, financial firms tend to behave the opposite - they benefit from higher costs of borrowing, which makes their lending more profitable."

An example of good themes to play now via sectors could be rate rises in the US versus QE in Europe. "An interesting pair trade could be US banks and European utilities as that's a play on both interest rates movements and QE," he says.