Exchange-Traded Funds: Sector Performance and Diversification

Abstract

This paper compares the performance of sector ETFs to their respective S&P industry GICS sector index and to their identified benchmark. We have defined sector risk exposure as the sector specific risk that cannot be eliminated via the portfolio’s diversification across the given sector. We employed regression analysis to analyze diversification across each ETF’s GICS sector and then applied Sharpe’s Single Index Market Model and the Sharpe ratio (excess risk adjusted returns) to evaluate performance. We found that these investment vehicles did not provide an investor with a level of sector risk exposure commensurate with the S&P GICS sector index during the period of analysis. Further, we found that 75% of the ETFs’ total risk is sector specific exposure, indicating that the remaining 25% of the ETFs’ total risk may be attributed to factors that are unique to the ETF (ETF specific risk). We also found that the proportion of ETF specific risk varied across the S&P sectors. Finally, our analysis of Financial sector ETFs’ performance indicates a divergence from their benchmarks and the S&P sector during the financial crisis.