Thatâs important because if youâre not market neutralâand
therefore not inclined to simply buy SPY and be done with it as a
means of achieving core equity exposureâyou need to know that
thereâs a bit of the devil in the details if you try to tweak
exposure using the sector funds.
Finding these quirks is why weâre 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:Thereâs a good reason why the 10 sectors
in the table below that comprise the S'P 500 get reduced to just
nine sector funds. Iâll get back to the reasons for that.
||Weight as of 2/3/2012
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.
Letâs start with Exxon.
The energy sector is so dominated by Exxon Mobil that the
companyâs weight is capped in the Select Sector SPDR energy fund,
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 firmâs 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
As you can see, Exxon isnât the only company whose weighting
changes in this reconstitution.
|Exxon Mobil Corp
|International Business Mach
|Chevron Corp New
|General Electric Co
|Johnson ' Johnson
|Procter ' Gamble Co
|Wells Fargo ' Co New
|Coca Cola Co
|JPmorgan Chase ' Co
|Berkshire Hathaway Inc Del
|Philip Morris Intl Inc
|Merck ' Co Inc New
|Wal Mart Stores Inc
General Electric and Coca Cola are both significantly
underrepresented in this hypothetical portfolio, although the
reason for this isnât entirely clear. Weâre still on the case
though, and once we crack it, weâll let readers know.
For now, we know that neither company is large enough to elicit
capping rules in each fundâs 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
The bottom line is that the exposure an investor would get in
this hypothetical portfolio is different than the exposure provided
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
The two companies are so much larger than the other five telecom
firms that itâs impossible to come up with a diversified tech
fund under the rules of the â40 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 â40 Act diversification
standards but, as you can now see, also happens to mix telecoms
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
Of course, this performance difference doesnât take into
account the additional transaction costs of buying nine funds as
opposed to one fund.
Then again, the point isnât that doing this will increase or
decrease returns. Thatâs impossible to predict. After all, we are
talking about the expected returns of individual companies, and
Iâm 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 donât roll up perfectly to create like exposure to
SPY and, more importantly, they donât 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
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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