Vanguard Sector ETFs Starting to Catch the Leader

Vanguard

State Street’s SPDR sector ETFs were the first to allow investors to invest in S&P 500 stocks by sector, and still are the most popular. Vanguard is right on their tail now though.

Many investors take a diversified approach to their stock investments, where they seek a wide exposure to different types of stocks in a variety of industry sectors. If you invest in the S&P 500 for instance, you hold various amounts of all 500 stocks in the index, comprising all the major sectors.

The rationale behind this is to look to balance sector risk, where if you invest in less than all the sectors that comprise this broad index, and your choices perform below the average of all of the sectors, you won’t do as well.

This approach seeks to treat different sectors homogenously, treating performance essentially as random, where more diversification would actually reduce your risk. If you asked just about any investor if adding more diversity would serve to reduce risk, and just about anyone who advises or works in the investing industry, they would tell you that it does, and would be puzzled if we told them that their view is based on misperception, because they are already so excessively diversified now.

Investors absolutely butcher the diversification end of their investment strategies, and it is this presumption of randomness and unpredictability that is the undoing of their understanding. If stocks really were unpredictable, there could not be any advantage in investing in them, which would reduce the exercise to betting on heads and tails with a fair coin and expecting to make anything from it.

Even the most confused academics, who believe stocks are somehow random in the short and medium term but not random and therefore predictable in the long term don’t really believe stock prices are random, they just think that they do or believe that we can somehow get non-random results from adding up random results, which is both absurd and mathematically impossible.

This is like saying that you can’t win this game of heads and tails unless you keep betting for years, and then somehow heads will win more over this very long period. Some people may think that a run of tails may make heads more probable, what is called the gamblers fallacy, thinking heads are “due” or something, even though the probability remains 50% with every flip and we know this to be true absolutely because it’s a condition of the experiment, whether that be for a few flips or an infinite number of them.

Investors know intuitively that stocks do not behave randomly, and there is no element of randomness whatsoever in their prices, just like the price of anything cannot be random because it requires intention, in our case the price points that buyers and sellers agree on at a given point in time.

We also know that stocks or stock sectors are not homogenous, like a commodity would be, as stocks and sectors are very much distinct and follow different price paths over time.

Some stocks perform better than others, and some sectors do as well. When we buy an index fund, we are actually ignoring this truth in favor for this random and homogenous view of stocks, whether we know it or not. Very few of us realize this though, but ignorance is not a particularly kind master, and not one we want to hand our financial prosperity over to.

People usually don’t get past the most superficial of perspectives on this, like it’s just better to invest in more stocks, not just all stocks, but certain ones that may be in an index such as the S&P 500. There are indexes that have a lot more than 500 stocks in it, but if you press them, and they do have some idea of why they are picking this particular index, they will tell you that they are looking for a basket of stocks that are representative of stocks in general, in other words, with all sectors represented.

Why Buy the Whole Bushel When You Can Just Pick the Good Ones?

It is not that these sectors are represented equally in the S&P 500, and far from it. Due to the way sectors have grown, this has allowed the technology sector to be far more represented than the energy sector for instance. As tech stocks keep going up, they grab a bigger piece of this pie, and while energy stocks go down, their piece of it shrinks.

If you buy the whole index though, this involves the hidden assumption that one stock is like another and one sector is like another. The reason why this assumption exists and is hidden is because in order for owning them all to make sense, this hidden assumption has to be true.

Otherwise, we’re shopping for apples blindfolded and assuming they are all the same, and end up wanting the best apples but ending up with a hodgepodge of them ranging from perfect to rotting and everything in between.

The first thing that we therefore need to realize when shopping for our own apples is that the various apples that we will be picking from among, the different sectors in the S&P 500 for instance, are not homogenous at all and differ considerably in their quality and desirability.

From the moment that stocks were first traded until today, these sectors have differed a lot, but somehow people think that while that has been the case, it’s all random going forward. The distributions from the past have been anything but random, and have instead followed distinct trends, the opposite of randomness. It is possible in theory that somehow, investor behavior would become randomized and they would choose their stocks blindfolded forever more, with absolutely no regard to what other people are doing, which is what makes the process non-random, but don’t count on it.

The reason why trends exist is because people trade stocks according to trends, and as more and more people are waking up to the idea that it’s better to buy a stock doing well than one doing poorly, trend following is becoming prevalent, improving their magnitude and predictability.

One sector may be trending better than another, and we can look at these trends to easily see that if one is performing better compared to another, this is more likely to continue than not. By actually looking at the condition of the apples, we can then not only tell the difference between the shiny tech one and the rotten energy one but we can use this information to benefit financially.

Wanting all these apples in our basket without even bothering to ever inspect the condition of the apples is the mistake here, but given how much people invest in the S&P 500 and other broad indexes, it’s a very common mistake indeed.

The idea of investing in individual sectors is not a new one, but its popularity exploded with the issuance of State Street’s SPDR sector indexes. Each of the 10 different sectors in the S&P 500 is broken down into its own SPDR ETF, where you can purchase each individually and give you control of what goes into your basket and in what proportion.

State Street commanded the sector ETF business so much that few investors even knew that they even had a competitor with these products, and they enjoyed true dominance as a result.

The Gorilla of Funds is Pounding Its Chest Over ETFs Now

State Street isn’t the biggest fund company out there, although they have moved up to #5 now, and $670 billion of assets under management is no small amount. They are only David compared to Vanguard, the Goliath in this play, who hold three times more in assets than any other fund company and manage $4.86 trillion. Like Crocodile Dundee would say, that’s a knife.

Vanguard may have gotten to the sector ETF fund party late, but they do know how to make noise. They didn’t become so huge from not knowing how to promote their funds to the public. When Vanguard speaks, people listen, a lot of people.

Their voice isn’t so loud as to get people from selling their SPDR sector ETFs and buying theirs instead, and since both funds have stocks from the same sectors, both trying to do the same thing in representing them, it’s not that there is any meaningful difference in performance between each company’s given sector fund.

This is all about how much new business, people who are not in sector ETFs but are considering them, that defines how these companies change in comparison over time, and these things therefore change rather slowly.

State Street still enjoys a big lead in all sectors but one, and it could be a while before the other 9 falls, but the technology sector has just become captured by Vanguard. While this is the sector that is growing the most in terms of sector ETF growth, where more new people are buying these than other sectors, it may be just a matter of time before Vanguard becomes crowned king of the sector ETFs in addition to ruling the world of funds overall.

Just like stocks, these things move in trends, and the trends take real time to change things. Vanguard is trending better than State Street, and this isn’t random, it is because they have succeeded in attracting more business. Just like with stocks and sectors, an advantage is more likely to be maintained than lost, so we should see this continue.

This is all good news for investors, as more competition is always a good thing. If there are two people fighting for your business, making the bigger guy fight harder as well as the smaller guy needing to fight hard enough will at least have some benefits.

We don’t want Windows vs. Linux, because few people really go for the little guy here, but Apple vs. Android is at least a fairer fight, where both look to win business away from the other. The growth of Vanguard’s sector ETFs does mean something, but it’s biggest impact by far is to use their huge reach to introduce more investors to the benefits of using sector funds.

Sector funds can be used any number of ways, anything that benefits of treating different sectors differently, given that they behave so differently. We should be selecting based upon trying to make more money from this game with a suitable level of safety, and sector funds help us do this better.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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