The search for sector exposure
The evidence that stock returns are being driven more by sector and less by country returns is becoming very widespread. Many research articles have been written, particularly about European markets, which support the view that country factors are becoming less and less responsible for explaining stock returns. Perhaps surprisingly then, country futures remain liquid, while sector futures have failed to take off on the two exchanges where they have been launched.
Even to the most casual observers it has become clear that France Telecom, for example, is more driven by the returns of the European (or global) telecoms sector than it is by the returns of the French market. Most market participants now believe that the majority of stocks are now dependent more on their sector than their country – the main exceptions are very domestic stocks, such as utilities and some retail companies.
An analytical approach to this issue is illustrated in Figure 1. We have calculated here the rolling average six- month correlation between European stock markets, as well as between European sectors. (Effectively what we have done is calculate the correlation between every European stock market, and then take the average of these numbers.)
The chart shows that the correlation between European countries has been steadily rising over time, while the correlation between sectors has remained stable, and recently has fallen significantly. In the late 1980s and early 1990s, country correlation was continuously below sector correlation, while since the late 1990s country correlation has been above sector correlation. Clearly, sectors have become more different as countries have become more similar.
One natural outcome of the acceptance that sectors are a more dominant effect has been to look at the sector exposure of portfolios at least as much, and typically more than, the country exposures. For most fund managers the preferred method of understanding where the bets and risks lie in a portfolio comes from a quick summary of the sector exposures. Most often, shortcut descriptions of European stock portfolios use terms like “we are overweight telecoms, underweight technology”, rather than “we are overweight Spain, underweight Finland”.
Surprisingly then, given this widespread shift to analysis and reporting by sector, the instruments for controlling asset allocation have not changed. Futures volumes have remained strong in the major European markets (although this is not the case for smaller markets). In addition, the attempts by futures exchanges to create futures contracts on sectors have not been successful. (For example, both the AEX and the MONEP launched select groups of sector futures – in neither case did meaningful volume trade.)
This failure of futures contracts on sectors at first appears to be a paradox. In survey after survey fund managers and brokers repeat that they believe that sector exposure is more important to them than country exposure, and yet when it comes to the main instruments for controlling asset allocation and risk, managers are clearly continuing to use the old country- based instruments.
This perhaps belies one of the myths about sector investment. Although managers do look at sector allocation and control their sector weights, they are mostly doing this from a bottom up level – that is, they choose the stocks that they like and then make sure that this gives rise to the sector allocations that they desire. There seem to be few managers that currently control sector allocation in the same way that they controlled country allocation with futures. Perhaps this is simply because the old instruments (futures) do not exist for sectors. It may also be that the decision processes for controlling sector bets are not in place in the same way as they were for controlling country bets.
Perhaps the main reason for the failure of the sector futures contracts is an inability to generate continuous liquidity in a sector future. Typically when we discuss new futures contracts with investors, their first question is to ask what recent levels of trading volume have been. If volume is low, most investors will avoid becoming involved. Sectors come in and out of fashion, more so than countries did. With country-based investment, at the very least the domestic investors would always remain interested in controlling exposure to their home market. With sector-based investment, however, a particular sector can languish without interest for months (consider for example pharmaceuticals stocks during the technology boom at the end of 1999). Futures, however, need continuous liquidity to survive. We believe that ultimately this will prove to be a significant barrier to the growth of liquidity of sector futures.
There are two types of instruments that we believe will fill this gap:
q Sector swaps Swaps, which are over-the-counter (OTC) instruments are already actively traded on sectors. In broad terms, a swap will always be traded with a broker as counterparty. The broker will either pay, or receive the return on the sector. Sector swaps are now trading almost continuously.
q Sector ETFs Exchange-traded funds (ETFs) are listed funds with mechanisms to allow creation and redemption of units versus the stock constituents of the fund. The most successful ETFs to date are US based: SPDRs (on the S&P 500) and QQQs (on the Nasdaq 100). Over the month of November 2000, SPDRs traded $1bn a day and QQQs traded $3.3bn a day, so liquidity is extremely strong. We believe that a number of providers are preparing to launch ETFs in Europe on sectors. ETFs will have the advantage that they cope well with periods of low liquidity. If you own an ETF which sees a significant fall in liquidity, then it is always possible (through a designated market marker) to exchange it for the underlying shares, and sell those instead. Since ETF pricing is very much a function of the liquidity of the underlying stocks, then ETFs should be expected to be a simple substitute for stock trading going forward.
ETFs already exist on about 100 indexes in the US, many of which are sector indexes. In Europe the number of ETFs is still small (four indexes exist in ETF form currently). However, State Street Global Advisors has announced its intention to launch a range of ETFs based on the MSCI Europe indexes and there are likely to be other launches on other indexes.
With new instruments becoming available, the question of whether investors should control sector allocation directly becomes more realistic. With sector swaps already liquid, and a high probability of sector ETFs becoming liquid, then the tools will be available. Quantitatively driven asset allocation processes have found it hard to adapt to sector-based asset allocation techniques, because the inputs required are so different. Country-based asset allocation relied on statistics such as GDP growth and inflation perameters, and clearly these do not exist for sectors. However many other managers have shown enthusiasm for controlling sector allocation directly. This includes hedge funds, who have been keen to take direct sector positions (sometimes to hedge stock positions, sometimes to take direct views on a particular sector).
Ultimately we believe that the future of sector trading looks bright. The new instruments becoming available will take sector trading and asset allocation from an academic topic to a practical reality. Fund management techniques are very lightly to change as pure sector exposure becomes easier and cheaper to obtain.
Sandy Rattray is a vice president at Goldman Sachs International in London