Beware of concentration in sector ETFs

iShares S&P 500 Consumer Staples Sector UCITS ETF (IUCS), iShares S&P 500 Industrials Sector UCITs ETF (IUIS), iShares S&P 500 Materials Sector UCITS ETF (IUMS) and iShares S&P 500 Utilities Sector UCITS ETF (IUUS) join a growing number of ETFs aimed at investors who want to take tactical views on a sector, for example, if they believe US materials companies are set to receive a boost from the policies of US President Donald Trump. BlackRock already has five US sector ETFs listed on London Stock Exchange and providers such as Ossiam, Source, Lyxor and Amundi also offer a wide range of sector-based ETFs covering equity markets including Europe, the UK and the US.

But sector-focused ETFs are highly concentrated and tend to have higher stock-specific risk, with the largest stocks accounting for a substantial proportion of assets. Some also have a relatively small number of stocks. This means they can be volatile so are not for the faint-hearted

"Sector ETFs tend to be very narrow and concentrated in the largest stocks by market cap of the indices they track," says Hortense Bioy, an analyst at Morningstar. "It is very common for the largest names to account for as much as 50 per cent of a sector-focused ETF's assets, and the top 5 can represent 30, 40 or even 50 per cent of its assets. These are generally not great investment propositions because of that."

iShares S&P 500 Materials UCITS ETF only tracks 25 stocks and its top 10 holdings account for more than 67 per cent of its assets, making it a very narrow proposition. iShares S&P 500 Utilities UCITS ETF is similarly concentrated with just 28 holdings, the top 10 of which account for over 60 per cent of its assets.

iShares S&P 500 Consumer Staples Sector UCITS ETF has 37 holdings with its largest holding, Procter & Gamble (US:PG), accounting for 12.2 per cent of its assets. Over 65 per cent of its assets are invested in its top 10 holdings. iShares S&P 500 Industrials Sector UCITS ETF is the least narrow of the four new ETFs with 67 holdings but its top ten holdings account for just under 50 per cent of its assets.

Concentration is common among regional sector ETFs but less so among global sector ones. For example, SPDR MSCI World Consumer Discretionary UCITS ETF (WCOD) tracks over 250 stocks with far less concentration on the top 10.

Sector ETFs are highly targeted investments based on the idea that a group of stocks in the same industry or sector are likely to perform in the same way at a given point in time, due to factors such as regulation, investment or political change. For example, in the second half of 2016 cyclical sectors such as financials, materials and industrials outperformed defensive sectors such as consumer staples and utilities, as investors flooded into stocks likely to benefit from economic growth and fiscal stimulus in the US.

Cyclical sectors also tend to outperform defensive sectors when bond yields and interest rates are on the rise. Financials in particular benefit from rising interest rates as banks can pass on higher rates to their customers.

Over 2016 the S&P 500 Energy sector index returned over 50 per cent and the S&P 500 Financials sector index returned over 40 per cent. But so far in 2017 US energy stocks and financials are both underperforming - the S&P 500 Energy sector had lost almost 7 per cent as of 7 April while S&P 500 Financials had returned just 1.16 per cent.

Sector performance is often short lived, making sector ETFs a risky bet and potentially expensive to own, if investors need to trade them frequently.

A way to invest in sectors in a more diversified way is factor ETFs, as there is a crossover between sectors and factors. For example, European financial stocks tend to be well represented in value factor ETFs, while consumer staples tend to feature heavily in ETFs tilted towards quality.

Ms Bioy says: "Typically you tend to find consumer staple stocks in quality ETFs - as well as minimum volatility and dividend-focused ETFs - because these stocks tend to be quality dividend payers and are also more expensive as a result."

Currently consumer staples represent 27.91 per cent of MSCI Europe Quality Index and 1.14 per cent of MSCI Europe Value Index, while financials represent 3.07 per cent and 36.6 per cent of these indices, respectively.

This is also the case with the MSCI World indices: financials account for 30 per cent of MSCI World Value Index but just 2.4 per cent of MSCI World Quality Index, and consumer staples account for 6.8 per cent of MSCI World Value and 16.4 per cent of MSCI World Quality.

In 2015 the MSCI Europe Quality Index outperformed value, gaining 9.32 per cent while MSCI Europe Value Index lost 4.41 per cent. But in 2016 MSCI Europe Value gained 24.40 per cent while MSCI Europe Quality returned 14.79 per cent.

Performance of iShares US sector ETFs

Source: FE Trustnet, as at 10.04.17

MSCI World Quality Index sector weights

MSCI World Value Index sector weights

Source: MSCI