iShares, SPDRs, Vanguard - Who Builds The Best Sector ETF?

• By Simon Maierhofer, Co-Founder
• On 12:07 pm EST, Monday February 23, 2009

SAN DIEGO (ETFguide.com) - Forrest Gump had it right: 'Life is like a box of chocolates. You never know what you're gonna get.'

Investing with sector ETFs can turn out to be like a box of chocolate as well. Unfortunately, some surprises ain't that sweet.

Even though sector ETFs may seem like they are created equal, they are far from being the same. In fact, there are huge performance discrepancies and patterns that, once identified, allow you to avoid 'profit thieves.'

The Select Sector SPDRs are the 800-pound gorilla in the sector investing arena. The Select Sector SPDRs are linked to the nine industry sectors derived from the S&P 500 (AMEX: SPY - News). Technically, there are ten S&P 500 sub-sectors, however information technology and telecommunication services are grouped together as one in the Technology Select Sector SPDRs (NYSEArca: XLK - News).

The security selection model for the Sector SPDRs is considered 'passive'. To illustrate, all industrial stocks of the S&P 500 are automatic constituents for the Industrial Select Sector SPDRs (NYSEArca: XLI - News). No further screening is necessary.

The security weighting also replicates the market capitalization methodology of the S&P 500. The largest companies (by market cap) dominate the index. Exxon Mobil (NYSE: XOM - News) for example accounts for 22% of the Energy Select Sector SPDRs (NYSEArca: XLE - News) while the Rowan Companies account for only 0.52%.

Vanguard and iShares apply a security selection and weighting methodology similar to the Sector SPDRs. The parent index for the iShares suite of ETFs is the Dow Jones U.S. Total Market Index while Vanguard sector constituents are drawn from the MSCI U.S. Investable Market 2500 Index.

PowerShares offers two complete suites of sector ETFs driven by different index engines. The PowerShares Dynamic series is built on the AMEX Intellidex strategy while the RAFI series is based on indexes by Research Affiliates Fundamental Indexes (RAFI).

According to RAFI, traditional market cap weighted indexes systematically overweight overvalued securities and underweight undervalued securities. According to research by RAFI, this creates annual performance drag of 2% to 3%.

To avoid the alleged performance drag, the PowerShares RAFI suite of ETFs selects component stocks according to fundamental measures such as book value, cash flow, sales and dividends. Stocks are then weighted according to their fundamental scores.

While this approach led to a slight outperformance of the PowerShares FTSE RAFI Consumer Services Portfolio (Nasdaq: PRFS - News) over the Consumer Discretionary Select Sector SPDRs (NYSEArca: XLY - News), most RAFI sector ETFs are the ones that have fallen victim to performance drag.

From the 2007 top to the 2008 bottom, the PowerShares FTSE RAFI Consumer Goods Portfolio (Nasdaq: PRFG - News) lost 32.21% - more than the Consumer Staples Select Sector SPDRs (NYSEArca: XLP - News). The PowerShares FTSE RAFI Materials Portfolio (Nasdaq: PRFM - News) displayed a similar market underperformance.

The PowerShares Dynamic Portfolios, based on the AMEX Intellidex methodology, performed better than the RAFI portfolios. One of the bright spots of this methodology is the PowerShares Financial Sector ETF (NYSEArca: PFI - News) which consistently outperformed the Financial Select Sector SPDRs (NYSEArca: XLF - News) in up, down and mixed markets.

The Intellidex model ranks companies from a universe of the 2,000 largest stocks quarterly based on a variety of criteria, including fundamental growth stock valuation, investments and risk factors. The highest ranked stocks are then divided into two quintiles: larger and smaller stocks. 16 of the larger stocks collectively receive a 40% weighting. 44 of the smaller stocks receive collectively a 60% weighting. Stocks are equally weighted within quintiles.

The set of PowerShares Dynamic ETFs performed solid during bull market periods and lagged since the October 2007 market top. The PowerShares Dynamic Healthcare Portfolio (NYSEArca: PTH - News) outperformed the Healthcare Select Sector SPDRs (NYSEArca: XLV - News) by 10% during the last year of the bull market and dropped 10% further than XLV from the 2007 to the 2008 low.

Not all sector ETFs are like a piece of chocolate. There are some real duds in between. Identifying those duds means more money in your pocket. The most recent issue of the ETF Profit Strategy Newsletter compared the suites of sector ETFs from the Sector SPDRs, iShares, Vanguard, PowerShares Dynamic, PowerShares RAFI and Rydex equal weighted.

The report analyzed the performance during bull market years, during the worst time of the bear market (2007 high to 2008 low) and during a mixed market (October 2006 - January 2009). The results show that two sector families consistently outperform while two proved to be the 'Bermuda triangle for profits'.

Sector ETFs perform according to certain economic patterns. As of late, all ETFs (aside from short ETFs) have fallen with the market. The ETF Profit Strategy Newsletter contains a short, mid and long-term market outlook, the Market Meter, past calls include: 'Dow to bottom below 7,500' (Oct. 08), 'Dow to top above 9,000' (Jan. 09) and 'Dow to fall towards November lows' (Dec. 08). You may consider this the 'one-stop shop' for sector investing.

Buzz up!