Is the AIG Deal Death Blow to the ETF Industry?

By Jim Wiandt

It's raining locusts and fire today, as the Republicans bail out another financial giant. Will ETFs bear the brunt of this socialism?

There you go ... I'm just doing my best to duplicate Matt Hougan's sham headline on a Srfire Way to Make Tons of Money in this market. And then he goes and writes a lamo tax-loss-harvesting article.

First of all, can I get in a "What's good for AIG is good for America!" here just to get that out of my system? Congratulations American taxpayers, you are all now proud shareholders in AIG. They don't call it AMERICAN International Group (AIG) for nothing. 

Second - IS it lights outs for ETFs and ETNs? It appears not. But there IS one big potential lesson to be gleaned from the last week's insanity. And that lesson is one about ... sector exposure.

You'd have trouble convincing me that the stock market is driven by ivory tower concepts of growth and value ... this week has highlighted the obvious point that it all happens in the sector trenches.

It's times like now when BIGTIME shifts are going on that small and large and growth and value fade into the background like Latin classes or Cartesian rationalism. It becomes clear that the markets are a street fight in the dimly lit alleyways of the sector neighborhoods. So bring out your brass knuckles, because there's a whole lot of pain going on.

What better time to break out the sector discussion once more. I recently had a lengthy email conversation with a reader (to remain nameless) who is trying to figure out ways to not let sector effect overrun his portfolio. Indeed, it's a great irony that some of the methodologies like the RAFI Fundamental indices or Wisdom Tree dividend-weighted funds, which are ostensibly DESIGNED to avoid such sector bubbles, have been some of the hardest hit funds in the turmoil around financials.

I recently debated the subject with our reader. His email started the conversation (his comments are in italics to help separate the discussion):

By now, you guys have got to be getting tired of my notes on sector matters but I'm going to go at it again anyway—on your article "The 15 Basis Point Portfolio and Bobo Collide."

The real story behind the performance in these portfolios is the obscene levels of exposure to financials. Period.

As inadequate as I believe much of Morningstar classification tools and approaches are, it's the only set that I've got for bucketing the assets and, so, I'll pass on what I gleaned from it. 

Nearly 26% of total holdings in the 7-ETF portfolio falls (quite literally, currently) into Morningstar's Financial Services bucket.

More than 24% total holdings in the 10-ETF portfolio resides in Financial Services.

And those proportions are after having already undertaken significant "rebalancings" in those ETFs since June 07—executed, by the way, through massive relative losses of value.

As for the 8 "selected" ETFs for use in comparing the two portfolios, same deal regarding the equities pieces. The Morningstar report that I ran this morning shows VWO at 21% Financial Services!  And that's "o.k."?  (and how much was it in Financial Services in June 07?).  And 26% of EFA and 19% of IWM in Financial Services!

Clearly, style, capitalization and "total market" equity indexes, lacking meaningful sector constraints, have severely limited diversification potential as they rather "actively" and fully participate in extreme sector bubbles. Just as was the case with tech and telecom during 2000-2002, seeking to manage equities risk while allowing massive sector over-weightings is a pipe dream.  Was it "appropriate" for a "risk manager" to have 27% of equities exposure to financials, as was the case with the S&P in 2000, or more than 20% in financials in 2007?  While those numbers certainly corresponded to market cap weightings within a "broad" (but highly sector concentrated) index at the time, were they in any way truly relevant to the economy?  What fraction of GDP or GDP growth was represented by tech and telecom in 2000 and by financials in 2007?  27% and 20%?  I think not. And, no, I am not advocating an earnings or fractional GDP screen or weightings system. We've got sector alternatives today for relatively cleanly and systematically containing a substantial portion of risk inherent in most broad market and style and capitalization-based indexes.

Looking for the smoking gun on the portfolios reviewed? Try the sector composition. Were those concentrations an intended outcome of the allocation constructed? Whether intended or not, those allocations are nothing more than what I would call "sector bubble surfing."

It's hard to believe those numbers are still so high. The truth is, people are relatively oblivious to how the markets swing on sector weightings. But the story is...everything. I remember at one point a couple of years ago, the S&P had a NEGATIVE 5-year return, but if you took out technology, it was +5% or something.

It really is an amazingly underreported story, particularly among the "asset allocator" types. We're talking about the drivers of the economy - of markets, and it's like they don't even exist, save as speculative tools. Something is badly off there. I just feel like we need to get our hands around it ... to bring the numbers up more frequently, play around with mixing and matching of portfolios and tilts against sector overheating.

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Any thoughts regarding the other email that I sent "Sectorally equally-weighted ETFs???" --- ETFs equally (or otherwise) weighting sectors?  Isn't that a pretty simple concept? 

I suspect you guys have a whole lot more pull with fund sponsors and index providers than I (actually, I've got practically zero, based on my inquiries/experiences over the last 3+ years). Is it just because I'm communicating through wholesalers and wholesalers, in general, know squat and are, for whatever reasons, disinclined to pass along "egghead" questions like mine? Don't other advisors look beyond the name of an index to arrive at an understanding of what they're getting their clients in to?  I got to believe that I'm not the only one out there throwing questions at these folks. Pretty damned frustrating (and one of the reasons, I suppose, that I'm not so quick to pat sponsors and index providers on the back).

Matt and I discussed this a bit, and his initial reaction was similar to mine ... that the general direction of thought (not overweighting sector bubbles) makes sense, but logistically, it probably doesn't. You're going to weight telecom or utilities equally to, say, energy? That sounds like a bit of a wild bet. I went into the data and looked at historical sector weighting (just for the S&P 500, attached) to see just how much of a wild bet. Take a look at the attached. Actually the crossover in weighting across pretty much ALL of the sectors is dramatic, which would help to make YOUR case.

And you do have a great point about the tremendous financials overweighting.

But my argument would be that the economy evolves, and while there are bubbles, lots of them and big ones, by and large these weightings are representative of genuine economic activity. Maybe you could run some metric that takes a look at valuations (current book, with allowances for growth, etc.?) but running a straight equal-weighted sector portfolio would make me nervous.

As a side note, there ARE RYDEX equal-weighted sector funds ... they equal weight the stocks IN each sector. I know that's not what we're talking about, but I thought I'd mention it.

What I REALLY think you're looking for is bubble protection, right?  So to me a more sensible approach would be a "fundamental" weighting like the FTSE RAFI (and maybe WisdomTree and maybe value) funds. The idea there is to track not market-weighted returns based on market valuations, but to track actual underlying economic activity. Ironically, a lot of those indexes got raked by the problems with financials - what it may be more difficult to account for than irrationality in market valuations, is irrationality or overreaching in economic activity. And there IS such a thing, of course.

My feeling is you need something more sophisticated than just straight equal weighting to deal with the issues you're talking about.

That is my quick take on this, but I'm happy to debate it/think about it some more.

In terms of contacts into the ETF product issuers, it's not like iShares will just launch a fund if we run it by them, that's for sure. But we do know all the people working on product development, and if we DO feel very strongly about a concept, we can likely get SOMEONE to launch it...

I'm not advocating an allocation equally-weighted or otherwise across sectors. Nor am I advocating any particular weighting scheme within each sector. But for discussion and illustration purposes, we've got to start somewhere and, accordingly, I rather generically have talked about equal weight across sectors.   

And while I believe that baseline allocation across sectors probably ought to be something other than straight equal weights (which quite arguably seems to over-weight telecom and, perhaps utilities and materials) I'd rather hold a portfolio of sectors equally-weighted than one weighted according to the migratory extremes that many indices like the S&P 500 engender.  US equities holdings in my portfolios are baseline weighted equally at 10.5% across nine sectors and 5.5% in telecom (excluding tactical over and under-weights).  I fully agree with you regarding the need for a sector weighting program more sophisticated than a straight equal-weighting approach but from what other point to you start? 

Unfortunately, I've not come across research that nails down baseline sector allocations from which any "tactical" over/under-weighting can be registered.  Both Morgan Stanley and UBS research, for example, quote allocation recommendations against the sector composition of the S&P 500 --- i.e., against a moving target --- meaning that they present no static baseline sector allocation levels.  As a practical matter, quite frankly, I could care less about the sector composition of the S&P 500, and how a current recommended allocation might differ from it, except as a curious aside that has no bearing regarding what constitutes a well-reasoned, and at least relatively static, baseline allocation schedule across sectors.

In order for an allocation to truly bring risk moderation to the portfolio it has to be rather agnostic - avoiding exposure overloads (and under-exposure) and, I'd argue, with respect to sectors in particular.

Moderation and less than full participation in bubble extremes (on the upward swing and the downward spiral) is what matters to me and, I think, to many investors and advisors.  And that, quite matter of factly, is not to be found in S&P-500 based, style-based and "broad" market approaches or others that are inclined to significantly participate in sector-weighting extremes (lacking in any or in any meaningful sector constraints). Research groups rather routinely set out base growth/value and capitalization allocation static baselines. Why not on the sector front? 

The reality is you simply cannot tame the sector over-exposure extremes in total market or style oriented alternatives without taking an extremely crude and broad shot-gun approach ...  Underweighting, for example, the whole value side (and value-oriented sectors) in order to simply trim financials and, then, overweighting the growth side in order to have the exposure in sectors other than financials --- is like using a chain saw to cut a bad, nickel-sized piece of cheese from a one-pound block. You can certainly get rid of the bad nugget that way but at what cost to the block?

Thank you for the feedback!

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This is definitely an interesting set of issues to look at. Again, I think the closest ideas around what you're looking for are probably the fundamentally weighted indexes ... which show MUCH more stable sector weightings historically and largely avoided some of the worst excesses - like the huge tech bubble for example.  Of course much of the data is backtested, but these are good, valid ideas in the right area.

You may already be familiar with the RAFI indexes or "indexes," but here's a link:

In particular, check out the sector charts on page 5 of the online version of the article...

While I'm not a fan of market-cap weighting, I'll quite gladly take it over approaches that address that matter but do so while taking on another form of extreme risk concentration. 

If the issue is containing sector concentration, one need not resort to the RAFI sector series to get it done. Weighting within the sector index is a secondary matter to the question of weighting across sectors. But on the matter of internal weighting within the sector, the RAFI approach, by design, takes on extreme weightings in value characteristics that render it DOA for me as an alternative.  And, if you wish to consider alternative weightings --- you can get a more reasonable/moderate portfolio-level profile of attributes just using the Rydex equal-weighted sector pieces.

Of the seven US sector based approaches, those that can make reasonable sense include Powershares Dynamic sector series, Rydex equal-weighted S&P sector series, iShares DJ sector series and Vanguard MSCI sector series. In other words, the only ones that I would categorically pitch into the dumpster are StateStreet's S&P 500, Powershares' RAFI and FirstTrust's Alphabits (yes, I meant to do that) --- purely on the basis of index attribute concentration issues specific to those series.

The info that I'm attaching (my messy work bench) needs quite a bit of cleaning up and updating so that all is expressed "apples-to-apples." I just haven't had the chance to "synchronize" it all and expand it in certain areas but I think that the somewhat messy picture regarding portfolio attributes, nevertheless, is still clear enough for some crude comparative work.

Over the last three years I've accumulated a fair amount of information on Powershares "Dynamic Portfolio" methodologies --- both in written form and through discussions with Powershares people. And, I think, that the screening and weighting methodologies employed do a reasonable job of fencing off risk - including in the sector series, while maintaining credible market cap distributions and valuation metrics. I do have a big, big problem, though, with a lack of publicly available information regarding their index methodologies and index data histories --- These are things that users simply and reasonably ought to demand (but there's no focal point for such a voice in the industry).  I think that sponsors and providers ought to be expected by the investing world to provide quite a bit of information as a baseline diet (both on statistics and on methodologies). On the sponsors' and index providers' side there are copyright and trademark laws.  And regulators ought to push fund sponsors and index providers to the wall on the data and methodology fronts while helping to aggressively defend intellectual property rights. Period. And for those who wouldn't touch a product for lack of understanding and lack of information regarding the methodologies and attribute dynamics --- I think that such a view on life makes a lot of sense.

I don't have any problem with back-tested data, so long as it is put to an appropriate use --- such as reviewing variability in index characteristics over time.  And by that I mean looking beyond the total return stats and into matters such as sector and industry variation, capitalization variation, P/E, P/B, P/S, RoE, etc., etc.  All of that stuff is "there" but fund sponsors and index providers, in general, do very, very little about making it available so that the dynamic characteristics of meaningful attributes can be thoroughly reviewed and vetted. Too many people, of course, focus first (and often exclusively) on total return historicals. And if that's all that is considered then one can paint just about whatever total return picture is desired --- and that sort of "artwork" is a serious problem for everyone.

Think about this ... Of all the attributes that can be isolated in a tradable, investable form - if the single most important driver of broad index performance (total market, style and other such approaches) among these is sector composition then sector composition makes sense as a practical, executable means to allocate and fence off risk. Whether one chooses to market-cap weight, equal-weight or take another alternative approach to weighting (e.g. Powershares dynamic sectors or RAFI sectors) within a given sector is a question of the second or third order --- an important one, but not the first one.

Regarding the article, there's some useful observations but I also think that there were some incredibly important angles completely, completely missed --- There was no attention or review given to equal-weighting or to alternatives focused on sector constraints as the first order of business.  Regarding the former, if the broad indexes used for comparison relative to RAFI were able to be "objectively" scaled and then equal-weighted how would RAFI's brain surgery stack up (on historical total returns, since that was the primary validating criterion used in the article, but also across a range of portfolio attributes)?  As for the latter, the article at least hints that important byproducts of the RAFI methodology are, effectively, sector constraints that impact performance.  Voila / Eureka !!!!!!!!!!!!!! ... see below (AND the sector charts in the article) ...

"One intuitive way to understand why fundamental indexes outperform cap indexes is to examine the volatility of the cap index's sector exposure vs.. the fundamental index's sector exposure. We show the sector exposures of the U.S. Fundamental Index 1000 vs.. a cap-weighted peer benchmark in Figures 7 A-B.

Observe that the cap-weighted index's exposure to the tech sector ballooned to almost 25 percent of the entire portfolio at the height of the bubble ( from an eight percent exposure in 1995). Compare that to the fundamental index's exposure of 10 percent in 2000 (from six percent in 1995). Cap indexes, like the Russell 1000 and S&P 500, were drawn into the tech bubble as the tech names rapidly appreciated in price and market cap. As P/Es increased into the stratosphere, more and more index money was forced into Internet and telecom companies, which in turn pushed the valuation level on those companies higher, fueling even higher P/Es. Fundamental indexes do not experience this problem. Under the fundamental indexing methodology, unless companies grow their cash flows, dividends, sales and book value faster than the rest of the economy, they do not receive additional allocations. In a fundamental index, stocks that were popular and trading at a premium in 1999, like Cisco, Worldcom, AOL and other tech names, would not receive overweights at the expense of the utilities, financials and energies, which produced larger and more robust cash flows."

So, if sector composition is a primary driving issue, why not start the carving there? Clearly a key outcome of the RAFI screenings applied is a sector profile that moderates the extremes that are part and parcel of the broad indices. Take a look at the S&P equal-weighted ETF vs SPY (and, if you can, take a look at the composition of each from June 2007). It's true there too (as of 7/31 - using Morningstar data, Energy, for example, is just more than half in RSP relative to SPY). 

Why make things so blasted complicated right out of the chute? This really is neither magic nor brain surgery. But it (RAFI non-sector constructs) is, rather matter-of-factly, a sector constraining operation in its outcome. I'd just throw in, though, that there are other characteristics of the output (such as extreme value weighting, even in the RAFI sector pieces) which ought to be weighed as well.

Take the time to walk through the same analyses referenced in the article but while wearing a set of sector glasses and I think you're likely to find that simply using sector constraints as the starting point provides a more clear, less "subjective" approach to alternative weighting. Isn't it cleaner and more practical to consider alternative weighting approaches by starting with constraint of weights across sectors and, only after that, moving on to how securities are weighted (market cap or otherwise) or screened within a given sector?

Shall we dive further into this with explicit consideration to the international front?

Perhaps the most compeling allocation-related research piece that I've come across in years is the one to which Matt provided a link a couple of months ago (Country, Sector or Style: What Matters Most When Constructing Global Equity Portfolios? An Empirical Investigation from 1990-2001). It also helps, in terms of the perspective taken, to strip away much of the bark on alternative weighting and "fundamental" indexing strategies.

Comments

[bigmoney:]

I didn't have time to read this entire posting, but when I studying Investing 101 a few years ago, I was concerned about top heavy financials in the market cap weighted mutual fund / ETF products. Equi-sector fund investing is easy to do now with ETFs, but that works best for large caps. As far as I know, there's no equivalent of SPDRs in mid & small cap. Even better would be additional sector products to be available that are globally diversified, or at least western europe, Japan, etc.

2008 Sep 17 12:19 PM

[xpatUSA:]

equally tongue-in-cheek, my ETF (GLD) is doing just fine, I'm pleased to say ;-)

2008 Sep 17 12:20 PM

[Rhett:]

xpat, you must have a different GLD than I have. Mine isn't doing worth a damn lately (except today).

2008 Sep 17 01:41 PM