A Potential Problem With Sub-sector ETFs

by: Tom Coyne

The end of 2005 saw the introduction of a slew of new index products around the world, particularly those using an exchange traded fund (ETF) structure. In theory, giving consumers more choice is usually a good thing. However, there are times when additional choice can cause consumer confusion, leading to either additional costs (paying for advice on the right choice to make), or, worse, inferior decisions.

I have an uneasy feeling that some of the latest index product introductions fall into this latter category. Specifically, the U.S. market has recently seen the launching or registration of new "sub-sector" ETFs, focused, for example, on insurance, oil and gas exploration and production, or biotech companies.

Let's start with the strongest positive argument for using these new sub-sector products. In the past, we have written about the relationship of an investor's labor income and the allocation of financial assets in his or her portfolio. In theory, the introduction of sub-sector ETFs should make it easier to construct an allocation to domestic equity that avoids "double exposure" to the industry sub-sector in which an investor generates his or her labor income (e.g., the case of an employee at ExxonMobil). This includes a situation in which part of an investor's compensation includes restricted shares (which cannot be sold) in his or her company.

A less convincing, though still positive argument in favor of sub-sector ETFs, is that they make it easier for an investor to (legally) take advantage of active investment insights he or she may develop in the course of his or her work. It stands to reason that the area in which most people are most likely to develop an active management insight is the industry where they work. It is the one where they start with the deepest knowledge base, and add to it the most timely information. Clearly, some of this is "material, price sensitive, non-public" so-called "insider" information that it is illegal to trade on (e.g., information that your company is about to make an acquisition). But some of it is not; often this takes the form of a conclusion (e.g., "this industry's profit outlook is improving -- or worsening -- faster than most people realize") that results from the combination of different small bits of information. In these cases, a sub-sector ETF may make it easier to profit from that active management insight (i.e., from the fact that your forecast differs from the apparent "market consensus" forecast).

However, this also raises a strong argument against sub-sector ETFs - their existence may also tempt more investors to become active traders, in the belief that they can earn higher risk adjusted returns than those on a broad-based index fund. Consider a simple, but telling example. Your Uncle Carl calls you up and tells you he's “going to beat the market by investing in these new biotech ETFs.