Summing Sector SPDRS = SPY?

By Paul Baiocchi,

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That’s important because if you’re not market neutral—and therefore not inclined to simply buy SPY and be done with it as a means of achieving core equity exposure—you need to know that there’s a bit of the devil in the details if you try to tweak exposure using the sector funds.

Finding these quirks is why we’re always on the lookout at IndexUniverse for interesting thought experiments that can teach us things that might be important to investors and advisors.

To cut to the chase:There’s a good reason why the 10 sectors in the table below that comprise the S'P 500 get reduced to just nine sector funds. I’ll get back to the reasons for that.

Sector Weight as of 2/3/2012
Information Technology 19.63%
Financials 14.27%
Energy 11.92%
Health Care 11.64%
Industrials 10.96%
Consumer Staples 10.87%
Consumer Discretionary 10.74%
Materials 3.71%
Utilities 3.54%
Telecommunication Services 2.72%


But first, investors need to know that if they start piecing together the different sector SPDR funds to try to achieve some semblance of SPYÂ(NYSEArca:SPY) , weird things are going to start happening to their allocations of Exxon Mobil as well as Coca-Cola and General Electric.

Let’s start with Exxon.

The energy sector is so dominated by Exxon Mobil that the company’s weight is capped in the Select Sector SPDR energy fund, XLEÂ(NYSEArca:XLE) .

This means that if you owned all of the Sector SPDRs in percentages based on their relative sector weighting in the S'P 500 as shown above, you would own substantially less Exxon than you should based on the firm’s relative size.

The top 20 holdings of the S'P 500, and their weightings in our hypothetical Nine-SPDRS-Funds-Equal-SPY portfolio are shown below.

As you can see, Exxon isn’t the only company whose weighting changes in this reconstitution.

Holding Index Weighting Hypothetical Portfolio Difference
Apple Inc 3.5100% 3.07% 0.4379%
Exxon Mobil Corp 3.3400% 2.19% 1.1527%
International Business Mach 1.8700% 1.64% 0.2270%
Microsoft Corp 1.8600% 1.63% 0.2307%
Chevron Corp New 1.7200% 1.71% 0.0107%
General Electric Co 1.6500% 1.16% 0.4915%
Johnson ' Johnson 1.4700% 1.49% -0.0176%
At'T Inc 1.4600% 1.28% 0.1821%
Procter ' Gamble Co 1.4200% 1.47% -0.0518%
Pfizer Inc 1.3400% 1.35% -0.0126%
Wells Fargo ' Co New 1.3300% 1.31% 0.0186%
Coca Cola Co 1.2700% 0.77% 0.4982%
Google Inc 1.2400% 1.08% 0.1564%
JPmorgan Chase ' Co 1.1900% 1.18% 0.0099%
Berkshire Hathaway Inc Del 1.1500% 1.14% 0.0070%
Intel Corp 1.1200% 0.84% 0.2838%
Philip Morris Intl Inc 1.0900% 1.13% -0.0437%
Merck ' Co Inc New 0.9600% 0.97% -0.0108%
Wal Mart Stores Inc 0.8900% 0.92% -0.0329%


General Electric and Coca Cola are both significantly underrepresented in this hypothetical portfolio, although the reason for this isn’t entirely clear. We’re still on the case though, and once we crack it, we’ll let readers know.

For now, we know that neither company is large enough to elicit capping rules in each fund’s respective sector, nor is either of those companies part of a sector that needed reweighting based on the diversification requirements of the Investment Company Act of 1940.

The bottom line is that the exposure an investor would get in this hypothetical portfolio is different than the exposure provided by SPY.



Ten Sectors, Nine Funds

Now a quick word on why the 10 sectors that comprise SPY translate into just nine SPDRs funds.

The problem is that the telecommunications sector only has seven holdings in the S'P 500, and two of those companies are Verizon and AT'T.

The two companies are so much larger than the other five telecom firms that it’s impossible to come up with a diversified tech fund under the rules of the ‘40 Act without going beyond the companies in the S'P 500.

To remedy this, SSgA rolled those seven telecommunications companies in the S'P 500 into its Technology Select Sector SPDR Fund (NYSEArca:XLK). That fund meets ’40 Act diversification standards but, as you can now see, also happens to mix telecoms with tech.

Differing Returns

The various differences we uncovered come out in the wash in terms of performance as well.

SPY has climbed 4.72 percent on a total return basis over the past year, while our reconstituted portfolio returned 4.96 percent.

Of course, this performance difference doesn’t take into account the additional transaction costs of buying nine funds as opposed to one fund.

Then again, the point isn’t that doing this will increase or decrease returns. That’s impossible to predict. After all, we are talking about the expected returns of individual companies, and I’m in no position to determine whether 50 percent less exposure to Exxon Mobil will derail your retirement plans.

What I am in a position to do is tell you how this little thought experiment leads to a more important takeaway:The Select Sector SPDRS don’t roll up perfectly to create like exposure to SPY and, more importantly, they don’t provide the neutral exposure to the sectors that investors may be looking for.

Because fund managers choose to structure the majority of products as diversified 1940 Act funds, they are beholden to registered investment company requirements on fund diversification.

In industries like telecom and energy, this makes it nearly impossible to create a truly neutral portfolio.

As such, any analysis done on sectors should incorporate the capping rules of available funds. In short, sometimes the exposure you are looking for is not available, but as long as you realize this, you are one step further to getting it.





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Copyright ® 2012 IndexUniverse LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing ETFs
Referenced Stocks: SPY , XLE , XLK

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