Due Diligence on Sector Leadership

To quell the recent rumblings, Matthew Bartolini performed a data-driven due diligence on the Select Sector SPDR lineup and its market leadership position in cost, liquidity, and assets.

Head of SPDR Americas Research

With dispersion elevated throughout the pandemic, investors have gravitated toward sector exposures to express their market directional views. In Q2, sector ETFs listed in the US had their most inflows for a quarter since Q4 2016,1  featuring certain sectors posting their largest monthly flows ever (Health Care and Technology) in April. We know this because sector investing is in our heritage, and we continue to discuss the role sector strategies can play in the portfolio construction process.

Oddly, however, based on a competitor’s technology funds recently overtaking XLK , the Technology Select Sector SPDR Fund, in assets – an event that has occurred before – there are some rumblings regarding the suite’s prowess and prominent position.

Rumblings can turn into rumors, and rumors can turn into beliefs – regardless of what the data says. And my team performs a lot of data-driven due diligence on strategies. So as to quell the recent rumblings, the following is a data-driven due diligence on the Select Sector SPDR lineup and its market leadership position in cost, liquidity, and assets.

Cost considerations
Costs are important. However, as we have discussed previously, expense ratios are just one piece of the total cost of ownership (TCO). Investors need to consider the bid-ask spread (i.e., trading costs) to really triangulate on the cost of utilizing a specific ETF to obtain an exposure.

The bid-ask spread for each Select Sector SPDR ETF has been a penny wide, on average. That means the suite’s average is a penny. And those spreads have stayed quite tight during periods of both tranquility and volatility. Meanwhile, the average bid-ask spread for the collection of the next 10 largest non-SPDR ETFs2  are much wider, and not a penny. What’s more, they may fluctuate randomly based on market conditions — specifically, during times of volatility, right when investors are likely seeking to reposition or meet client cash flow demands (i.e., when they need liquidity the most).

The chart below plots the averages throughout 2020 for these two “suites” to illustrate the SPDR Suite’s clear advantage from a trading cost perspective and, ultimately, from a total cost view as well.

Source: Bloomberg Finance L.P. as of 07/09/2020 based on calculations and classifications by SPDR Americas Research. Past performance is not a guarantee of future results.

TCO math example
For sectors, one could – and I will – argue that bid-ask spreads are far more important than expense ratios in terms of costs. Sector investors rotate quite often based on market dynamics, and that can lead to a high amount of turnover – a key factor in assessing the total cost of implementing a portfolio.

For example, I ran a simple momentum screen3  for each sector and built a portfolio that, each quarter, would purchase the top three-ranked sectors at equal weights. If the frequency was monthly, the trading costs would be higher. I chose quarterly so as not to appear as if I were using the highest frequency possible to make a point, but also to be reasonable – as a semiannual or annual sector rotation strategies are unlikely.

To show the impact on transaction costs, I ran this for the Select Sector SPDR Suite and its next-largest sector suite competitor, utilizing the actual average bid-ask spreads during the observation period (June 2018 to June 2020). The expense ratios are 0.13% for the Select Sector SPDRs and 0.10% for the competitor. The average bid-ask spread in basis points is 0.02% and 0.04%, per product per suite, respectively. The turnover for this strategy was 109%, and 41 trades were made.

The result? All it takes is the first trade to make up for the expense ratio difference. Only a fourth of the expense ratio is levied (i.e., one quarter’s worth), but 100% of the trading cost are felt as soon as the trades are put on. And once the portfolio begins to rotate toward the sectors with the strongest momentum, the costs to trade and obtain that exposure noticeably increase and compound – eroding any 3 basis point expense ratio advantage. The compounding is centered based on two things: the turnover — which was 200% at one point, as leadership drastically changed — and market liquidity during times of stress, when spreads widened out.

After two years, the expenses paid are 30% higher when using the Select Sector SPDR Suite. However, the trading costs are 63% lower. As a result, the TCO of running this strategy for two years is 37% lower when using the Select Sector SPDR Suite versus its next-largest competitor. See the chart below.

Source: Bloomberg Finance L.P. as of 07/09/2020 based on calculations by SPDR Americas Research. Past performance is not a guarantee of future results.

Liquidity leadership on display
Analyzing liquidity differences among sector vehicles is crucial. A lack of liquidity at a time when you need it most can increase costs and present issues (delayed execution, uneven pricing, etc.) – a notion on display during this period of sizable volatility and uncertainty.

An ETF’s trading volume is a reasonable measure of a fund’s potential liquidity. As a result, comparing trends in trading volume is crucial to understanding the liquidity available in a product. The identifiable trading patterns in 2020 serve as a good example of liquidity formation, and the suite’s trading volumes have noticeably spiked this year from an already leading market leadership position.

Over the past six months, the Select Sector SPDR Suite traded daily, on average, 140% more than the rest of the sector ETFs listed in the US ($10.8 billion a day versus $7.7 billion)4  – COMBINED. So far this year, the suite’s cumulative total trading volume surpasses $1.4 trillion. Meanwhile, the rest of the sector ETFs listed in the US have only $1 trillion – again, COMBINED.5

While the suite’s 58% share of industry volumes is impressive, that percentage ballooned to 70% during some of the most volatile days of the pandemic. Based on the data, it is clear that the market chose the Select Sector SPDRs as its tools for action, with investors looking to the SPDR Suite when they needed liquidity the most.

Source: Bloomberg Finance L.P. as of 07/09/2020 based on calculations and classifications by SPDR Americas Research. Past performance is not a guarantee of future results. 

Market sizing and depth of bench
This analysis of market leadership was spurred by the rumblings of XLK no longer being the largest pure technology ETF – a title it just reclaimed in June, as this moniker has traded hands numerous times over the past few years. And there is a structural reason as to why the difference is so tight: up until September 2018,6  XLK wasn’t even classified as a pure technology ETF. Prior to the GICS re-map, XLK included the three telecom stocks in the S&P 500, as the S&P 500 telecom sector could not be covered by an ETF since a 40 Act registered fund cannot own just three stocks.

That XLK historical nuance needs to be mentioned in the context of any comparison, and it usually isn’t.

And to say that XLK no longer being the largest tech ETF today somehow weakens the entire suite’s prominence completely ignores the depth of the suite. Nine out of the 11 funds are the largest in their respective segments,with the average differential between a Select Sector SPDR and the next fund being $7.6 billion.

Similar to the liquidity uptick, market share has increased as investors have turned to the suite to make allocations based on today’s market. To date, the Select Sector SPDR Suite has increased its market share of sectors — even in Q2, when XLK was edged out as the sector leader in assets. The Suite’s sector assets increased from 35.2% at the start of 2020 to 36.2% at the end of Q2.8  These numbers increase further if you include the companion SPDR industry lineup (40.4% overall market share, up from 40.1%) that is part of our overall tactical sector capability set.

Select Sector SPDR Suite: A Market Leader in Size, Liquidity, and Cost
In addition to having the most assets, highest liquidity, and lowest total cost of ownership, the Select Sector SPDR Suite also lays claim to the deepest ecosystem of investors. The suite’s total amount of option open interest notional is 127% greater than those of the rest of sector ETFs listed in the US – COMBINED.9  Additionally, the SPDR Suite has 150% more in notional short interest.10  The fact that derivate-based arbitrage — and long-only investors —may favor the Select Sector SPDR Suite reinforces the suite’s diverse client base and overall portfolio implementation flexibility.

Overall, one data point doesn’t make a trend. When performing due diligence on implementation vehicles, you need to look at all the data to understand if there is a change taking place that requires a refresh of an asset allocation mix or an industry viewpoint on “dominance.” Based on this data-driven analysis, the Select Sector SPDR suite remains the largest, most liquid and lowest-cost option for investors expressing views on sectors.

To learn more about sector investing opportunities, visit our dedicated sectors webpage .