iShares New Evolved Sector ETFs Need More Evolution

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Includes: IECS, IEDI, IEFN, IEHS, IEIH, IEME, IETC
by: Kurtis Hemmerling
Summary

iShares Evolved Sector ETFs try to fix a problem where one company has multiple sector exposures.

They use text analysis and machine learning to determine sector allocations of a company.

Stocks are divvied up by market cap.

This method isn't perfect because while it identifies sectors within a company, it has no method in place to isolate it.

I used to know what a sector was and how to determine which stocks were in it. It used to be easy. I would look for the GICS (Global Industry Classification System) and BOOM! Now, I am not so sure.

Sector ETF Scrabble Image

According to BlackRock, a company is no longer classified so easily. And they have produced a new set of Evolved Sector ETFs for investors wanting this new way to look at sectors and stock classifications. How does it work? Should you buy into this new sector classification system?

Traditional Sector Funds

Sectors used to be fairly straight-forward with small, and sometimes big, changes taking place to the GICS every now and then.

  • The Telecom sector is changing to a much broader Communication Services as of September 28, 2018.
  • Real Estate emerged as its own sector from Financials on August 31, 2016.

To some, this is little more than a label which doesn’t affect the way they invest. An investor might want to own Apple (AAPL) and Disney (DIS) without any consideration as to whether they are classified as being part of the Technology, Consumer Discretionary or Communications sector.

But if you invest in sector ETFs such as these SPDRs, you may need to re-examine your objectives as the underlying stocks are about to be switched around with changes to your portfolio.

Ticker

Name

(XLB)

Materials Select Sector

(XLE)

Energy Select Sector

(XLF)

Financial Select Sector

(XLI)

Industrial Select Sector

(XLK)

Technology Select Sector

(XLP)

Consumer Staples Select Sector

(XLRE)

The Real Estate Select Sector

(XLU)

Utilities Select Sector

(XLV)

Health Care Select Sector

(XLY)

Consumer Discretionary Select Sector

(XTL)

SPDR S&P Telecom

One Stock But Multiple Sectors

One of the main problems with trying to classify a stock is that its business might cross into various sectors.

  • Netflix (NFLX) offers a Consumer Discretionary service, but has its roots in Technology and seems to be a fit with the newly created Communications sector.
  • And how exactly do we classify Amazon (AMZN) which has its fingers in all sorts of pies? It started as a book company, but now is involved with creating TV shows, healthcare services, food and online retailing. It embodies multiple sectors.

iShares Evolved Sector ETFs

This is the problem that iShares seeks to solve with its new suite of Evolved Sector ETFs. How does it work?

The first step is to determine the sector breakdown of an individual company. One firm might belong to numerous sectors. How is this determined? Below is an excerpt from the iShares Evolved Sector web page:

The evolved sector approach uses text analysis, guided by machine learning statistical techniques, to identify words and phrases companies use to describe themselves in publicly available materials such as regulatory filings and earnings reports. Companies are grouped into sectors based on similarities in the language each uses when describing their businesses (see Figure 1). In the example below, words in larger font sizes occurred with greater frequency among the listed companies and had greater relevance.

In addition to this, iShares is adjusting the sectors.

iShares Evolved Sector Allocation ETFs

Here is the current lineup of Evolved Sector ETFs:

  • iShares Evolved U.S. Healthcare Staples ETF (BATS:IEHS)
  • iShares Evolved U.S. Discretionary Spending ETF (BATS:IEDI)
  • iShares Evolved U.S. Media and Entertainment ETF (IEME)
  • iShares Evolved U.S. Financials ETF (BATS:IEFN)
  • iShares Evolved U.S. Technology ETF (BATS:IETC)
  • iShares Evolved U.S. Consumer Staples ETF (BATS:IECS)
  • iShares Evolved U.S. Innovative Healthcare ETF (IEIH)

Placing One Stock in Two Sectors

So let us suppose that one stock lives in two sectors. How is this managed in a practical way?

We will use the example of Home Depot (HD):

  • Assume that after machine learning text analysis, the company is determined to be 75% Discretionary Spending and 25% Industrials.
  • Market cap is $206 billion.
  • 75% of market cap ($154.5B) is weighted into the Discretionary Spending sector.
  • 25% of market cap ($51.5B) is weighted into the Industrials sector.

And keep in mind that this could change over time. Perhaps text analysis of future filings suggest an 80/20 split. In this case, the weightings of Home Depot in each sector will be adjusted.

What I Like – What I Don’t Like

The idea that a company can belong to multiple sectors is a novel idea that makes good sense. The idea is great!

What I don’t like is that there isn’t any method to separate the cash flows from the different components of the company. Dividing the market cap up is an imperfect solution – although it might be argued that it is better than the existing one.

Let’s see how this could affect a sector fund in the following extreme example using 2 stocks.

Traditional Sector Allocation

  • Stock A – 90% Technology and 10% Discretionary Spending. Market cap $100 billion.
  • Stock B – 90% Discretionary Spending and 10% Technology. Market cap $10 billion.

Under the current GICS system, each stock would be 100% allocated toward each sector. Now you could argue that each sector is a bit watered down since each stock has 10% of its business in a different sector. When analyzing each company, you could say that each sector fund is 90% pure.

Evolved Sector Allocation

Under the ‘evolved system’, the stocks would be portioned out according to cap-weight.

  • Technology sector would have $90 billion (90% of cap) of stock A and $1 billion (10% of cap) of stock B.
  • Discretionary Spending would have $10 billion (10% of cap) of stock A and $9 billion (90% of cap) of stock B.

Do you see the problem? Discretionary Spending sector has a cap of $19 billion and is now over 50% weighted with a stock which has only 10% exposure to that sector. Even though stock A is only 10% in the Discretionary Spending sector, it overwhelms the fund due to its market-cap.

Yet Another Example

Consider another example:

  • 11 stocks which all have a market cap of $1 billion.
  • 10 stocks are 10% Energy sector.
  • 1 stock is 100% Energy sector.

In the Evolved Sectors weighting scheme, this fund has 50% weighting towards the 'pure' Energy stock and 50% weighting towards stocks which have only 10% Energy exposure. You could argue that 40% of this fund isn't Energy at all.

In the old classification system, only one stock would be included in the Energy sector for a purer sector play.

Summary

iShares is attempting to redefine how stocks fit into the various sectors by dividing up the market cap. It is an interesting idea that a company can belong in multiple sectors and adjust its weighting to each sector over time. But the tools do not exist, at this time, to perfectly implement this.

If there was a way to separate the cash flows of the various components of a company and invest directly into these, then we could have a pure sector breakdown within a company. But dividing up market cap doesn’t quite get you there. It is sort of like mixing a bottle of beer and glass of wine in a container and then pouring the mixture into 2 glasses. You still didn’t separate the beer and the wine. And the problem gets worse when very large cap companies have small exposure to one sector – this can really overweight a certain sector with companies that don't belong there.

Of course, the alternative is to place a company in a certain sector if the majority of its business is derived from that sector. This isn't perfect either. Perhaps there is another solution that involves neutralizing sector exposures by shorting other sector funds and using leverage in others. Maybe there are other ways to try to isolate the sector specific returns in a company.

I give iShares and A+ for the idea, but a B- for the execution. The reality will likely not be as bad as my worst case scenarios listed in this article, but it will undoubtedly fall short of my expectations of what it is trying to achieve.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.