If you intend to pursue US sector rotation investing with ETFs, you probably want to be sure that your choice of funds covers the entire US market without unintended gaps or overlaps in your exposure.

There are many funds with sector focus that pose a bewildering menu. On top of that is inconsistent labeling of levels by index companies, and fund descriptions using labels that are inconsistent with the labels used by the indexes they follow.

There are two industrial classifications systems competing for your attention. The older one from S&P and MSCI is called GICS (global industry classification standard). The newer one from Dow Jones and FTSE is called ICB (industry classification benchmark).

They each have 10 top levels, called “sectors” by GICS and called “industries” by ICB. Beyond the top level both the names and number of classes differ.

The GICS structure consists of 10 sectors, 24 industry groups, 67 industries and 147 sub-industries. The ICB structure consists of 10 industries, 19 supersectors, 41 sectors, and 114 subsectors.

The 10 top levels are very similar, but not the same. The consumer category is the most different between systems, as the table shows. They are not fungible. You would need to combine the two consumer categories of each for them to be equal.

Other differences exist. For example, ICB puts coal in their mining component of Materials, whereas GICS puts coal in the oil, gas and consumable fuels component of Energy.

When you read about or plan sector weights or industry weights, make sure you know which system, GICS or ICB, is referenced. The weights are not the same for each.

Note that in both systems, telecommunications equipment manufacture is in the Technology category, while telecommunications service provides are in the Telecommunications category.

The State Street sponsored sector ETFs are based on the 10 sector GICS system, but they have only 9 sector funds. State Street combines the Technology and Telecommunications sectors into a single ETF called Technology (XLK).

The Vanguard sponsored sector ETFs are also based on the GICS system, but they use all 10 sectors, keeping Technology (VGT) and Telecommunications (VOX) separate.

The Barclays sponsored sector ETFs are based on the ICB system, and they use all 10 industries of that system, but call them sectors, presumably because of common usage established years earlier by the GICS system.

The names of the sectors as they relate to top level sector ETFs from the three key sponsors are shown in the table, which also shows the broad US index fund from which the sector funds are derived.

Beyond sector funds are a plethora of subsector funds of varying degrees of granularity. If you use them, know whether they are based on GICS or ICB and read the structure of each classification system, so that you will know whether and to what degree you will overlap the holding of top level funds you may also own.

The links to the classification structures are:

• http://www.icbenchmark.com/icb_structure.html

• http://www.mscibarra.com/products/gics/structure.jsp

Three practical ways to use top level sector funds are:

1. own the broad index fund as a core position and then selectively overweight your portfolio toward a particular sector by buying some of that sector to supplement your core broad index position
2. own all of the top level sector funds, instead of a core broad index fund, in whatever allocation policy weight you determine (presumably at or deviating from the overall market weights), then reallocate or rebalance from time to time
3. do not own the core broad index fund; do own those sectors for which you are confident; and do not own those for which you are not confident (most aggressive and highest risk of the three approaches).

Subsector specialty funds, should probably only be used as “spice” here and there in conjunction with a core broad index fund.

Whatever, you do, a little bit of reading can help a lot. Relying on labels alone could give you a false sense of security. Be particularly careful when using sector funds from more than one sponsor to make sure you do not have unintended gaps or overlaps.

Richard Shaw
QVM Group LLC

[ Securities Mentioned in this article:

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The Investment Company Institute reported $26 trillion worldwide mutual fund assets from 26 reporting countries for the year 2007.

They reported assets for 2002 - 2007 which shows a 5-year average increase in total assets of 18.3% (net new money + performance), and a 2007 asset increase of 23%.

It is interesting to see how investors worldwide in the aggregate have committed their money, and which parts of the world have placed the most money into mutual funds.

There are about 66,000 mutual funds in total. That is probably substantially more funds than there are investable stocks.

The Americas (including all of North and South America) hold just over 1/2 of worldwide mutual fund assets. The Africa/Asia component will likely increase as a percentage as their populations become more affluent.

The allocation of assets by fund type differ significantly between US investors and non-US investors. US investors make a somewhat larger allocation to equities than the rest of the world.

It is interesting to observe that the effective asset allocation of US investors is 57% stock and 43% bonds and money markets (estimating a 50/50 mix of stocks and bonds in the “Balanced/Mixed” funds category). That is quite similar to the classical 60/40 stock bond allocation, such as available through the Vanguard Balanced Fund (VBINX, expense ratio 0.19% for small accounts and 0.10% for amounts over $100,000).

When you consider how US investors have experienced the “friction” that Warren Buffet has defined, US investors have given up a lot to get somewhere they could have gotten more cost effectively. That friction costs investors $12 billion for each 1/10th of 1% in asset management expenses, and does not include fund sales loads, trade execution costs or income taxes due to active trading.

On the other hand, a fund such as VBINX has no sales loads, bare bones management fees, and a tax efficient passive index approach.

Overall, US investors have given more to fund management companies, Wall Street brokerages, fund sales agents and the Internal Revenue Service than they needed to do.

That same balanced approach is also easily achievable through ETFs by combining a broad US stock market ETF and an aggregate bond market ETF — with favorable entry costs (perhaps $10 - $25), favorable costs of staying in (perhaps 0.09% to 0.20% annual expenses), and low tax drag due to use of passive index funds that have minimal trading except for rebalancing.

Examples of broad US stock market ETFs available from the three largest ETF sponsors are:

• VTI (0.07% expense, from Vanguard)
• IWV (0.20% expense, from Barclays)
• IYY (0.20% expense, from Barclays)
• TMW (0.20% expense, from State Street)

Examples of aggregate US bond market ETFs from the same sponsors are:

• BND (0.11% expense, from Vanguard)
• LAG (0.13% expense, from State Street)
• AGG (0.20% expense, from Barclays)

We are not suggesting that a balanced fund approach is right for everybody, or that skill cannot out perform the market — but we are saying that in the aggregate US investors left a lot of money on the table for managers and distributors by effectively creating a $12 trillion balanced mutual fund simulation.

Lesson — if you buy funds of any type (mutual funds, ETFs or other), make sure that you are not working hard and expensively to recreate an overall broad index. Either tilt away from overall market composition with reason and conviction, or buy an overall market index with one or two funds.

In any case, seek a low cost of entry, a low cost of staying in, and a low cost of exit, with no more tax penalty than is essential to accomplish your exposure objectives and risk management.

Richard Shaw
QVM Group LLC

The news is constantly full of “investment themes” — BRIC, commodities, falling Dollar, alternative energy, mortgage crisis, and so on.

Investing with themes is a good idea, because you will be swimming with the stream instead of against it. However, themes don’t last forever.

Getting onto a theme too early can be costly in terms of losses or “dead money”. Getting in too late can result in underwhelming profits or even losses, if everybody else is exiting when you are entering.

Whatever theme you may be contemplating, we think it is useful to analyze it in terms of generic theme dimensions. From our perspective, those dimensions are:

• Development Time
• Strength
• Duration.

Properly classifying themes will help you decide if they are right for you. For example, a fast development, weak and short duration theme is suitable only for the nimble — essentially short-term traders. On the other hand a slow development, strong and long duration theme is not really suitable for a trader, but may be suitable for a long-term investor in an asset allocation program. There are many degrees between those two extremes.

To help you with classification, we have developed this three-dimensional chart that creates 27 theme categories:

Richard Shaw
QVM Group LLC