State Street’s Select Sector ETFs represent the nine segments of the S&P 500 (ETF SPY). The goal of this strategy was simple in that we sought to offer a portfolio optimization technique with these segments instead of only investing in the broad market. The S&P 500 weights for these nine Select Sector Funds are in the table below.
For example, if there is a view that the discretionary consumer sector is overvalued, then there is a way in which to express this investment opinion. An unconstrained hedge fund could do this with a short sale of stock(s) from the Consumer Discretionary SPDR and a long position in stock(s) from a sector with the potential to outperform. This technique may be too complex in a traditional wrap account or IRA. Therefore an alternative approach in a long only account is to replace the consumer sector with the other eight sectors. The decision then rests on whether or not to hold the consumer sector weighting - 10.1% - in cash with a constant weight in the other sectors, or to over weight the other sectors by fully investing cash.
Regardless of the approach, this will short the consumer discretionary sector relative to the broad market. Below is an example of a cash weighting and a proportional re-weighting of the sectors. The proportional re-weighting over weights each sector to its representation in the broad index, which is another way of applying leverage to the investment decision.
Our curiosity did not end with just one solution. Since other ETF providers offer sector allocation products, we compared the State Street Global Advisor products with some of its peers. iShares, being the powerhouse in the ETF industry, was a natural place to turn for an apples-to-apples comparison of sector funds. The table below shows similarly branded ETFs from iShares and their 5-year performance return. The difference between portfolio and index returns is very close to, but not precisely, the management fee of each ETF, which shows that iShares has a management fee near 0.45% (45 basis points) on each fund.
The State Street Global Advisors Select Sector Funds have annual management fees around 0.20% (20 basis points). For what would appear to be a similar product, State Street charges less than half the fees as iShares. Beyond absolute management fees, there are other notable differences. First, the Dow Jones U.S. Index is the benchmark for iShares products, and this index is comprised of over 1,300 issuers as opposed to 500 stocks in the S&P 500. While correlation is high for the similarly branded State Street and iShares sector ETFs, differences in index composition will cause a like difference in investment performance. Both firms do a fine job generating investment performance relative to their benchmark less management fees. However, when the performance differential differs markedly from management fees, it exposes a critical difference in the management style. This issue is observed in the table below where it is evident that the Financials SPDR (XLF) generated five-year portfolio returns of only 8 basis points less than its index while the fund charged 0.21% in fees.
The financials portfolio outperformed – relative to its management fee differential - because of the way State Street allocates its security lending income to their funds. As background, fund managers can earn extra fees lending stocks to other counterparties so that they can cover short sale transactions. The swoon in the financial sector in 2008 created a demand to sell short equities in this sector. As a result, this demand for securities lending generated extra fees that helped the fund to earn a higher return.
iShares Financial Sector Index Fund has a 0.47% management fee, thus any performance boost was a result of the security lending fees shared with their ETF holders. However, the amount which iShares shares with their ETF clients differs from the State Street funds. The iShares Financial Sector fund generated $1,863,016 in security lending income for the year ending April 30, 2010, but $945,203 was paid to the ETF holders while the manager retained the difference. State Street’s Financials SPDR earned $20,965,067 in security lending income for the year ending March 31, 2010 and paid $17,821,508 to ETF holders. The dollar amount of security lending income is disproportionate because of the size of each fund, but State Street retained only 15% of its securities lending revenue while iShares retained almost 50%. Furthermore, iShares Financial Sector Index Fund has a higher management fee than the State Street Financials SPDR.
The management styles might be different enough for an investor to express their view of a sector with a more advanced hETFund strategy. For example, in the financial sector an investor could buy the State Street ETF and sell short the iShare product. These funds have a one-year correlation of 99.5%, and a long/short strategy will capture the difference between management fees. When a sector experiences extreme volatility, then the proportion of security lending fees could become large enough to influence portfolio performance: Where the spread differential might rise by holding a long position with the State Street fund and a short position in the similar iShare product. This concept can also be extended to the options market where an investor can engage in a long position with the State Street fund and sell naked calls on the iShare product if volatility is higher on its ETF (or vice versa).