I was recently quoted in ETF.com and its sister publication, ETF Report, in an article titled Global Sector Investing in Early Stages.

The article discusses global sectors – and in particular, global sector ETFs – and why they haven't seen the growth of their domestic peers.

At Newfound, we use iShares' suite of global sector ETFs in our Risk Managed Global Sectors portfolio.  For the objective of the portfolio – to seek to materially participate in global equity growth while sidestepping material drawdowns – we believe a sector-based framework is the best framework for managing risk.

However, we also recognize there are many reasons why these ETFs have not seen traction.  And I think several were overlooked by the article.

In our opinion, ETF adoption is a full ecosystem story, from the ETF strategist community to financial advisors to market makers.

And the reality is, country-based allocations are "easier" than international/global sectors on almost all three groups.

What does "easier" mean?

We'll start with the easiest first: market makers.

Consider that the iShares MSCI Germany ETF (EWG), according to ETF.com, has an average spread of 0.055%.  The SPDR S&P International Consumer Staples ETF (IPS), on the other hand, has an average spread of 0.51%.

Why?  What's going on here that spreads on countries are so much tighter than spreads on international sectors?  I mean ... I could trade in and out of EWG 10x before I exceed the cost of trading IPS once.  That's significant.

For market makers, country exposures are easier to hedge than sectors because of isolated currency risk and available futures.  For example, a long EWG exposure held by a market maker could be temporarily hedged with something like a short DAX futures position and long EURUSD futures position.  This hedgability leads to lower costs and better liquidity since market makers have lower costs in participating.

IPS, on the other hand, currently invests across 19 countries with approximately a dozen currency exposures.  That's going to make it a much costlier proposition to hedge.

For strategists and financial advisors, we believe "easier" is all about how they think about asset allocation.  We typically see a fairly traditional hierarchy.  The first decision that gets made is among the major asset classes: equities, bonds, cash, alternatives, etc.

Within the equity bucket, the traditional model is to divide the equity allocation into domestic and international buckets.

For investors who then want to further subdivide the domestic and international buckets, they are likely looking to do so along the axis that can deliver the most potential outperformance.

In the U.S., the two real alternatives are sector-based or style-box based.  For those seeking outperformance, dispersion is a key metric.  On average, over the last 15 years, the dispersion between the best and worst performing sectors has been 10% whereas among style boxes it has only been 4%.

In other words, there is a lot more benefit for making a right call on the sector side than on the style box side.

Internationally, there is actually a bigger dispersion among countries than there is sectors (~11% among the 10 largest countries versus 9% for sectors).  Couple this with the fact that economic analysis fits more neatly within a country-based framework and you have  a recipe for country-based dominance.

So we believe that a lot of this goes back to investors historically prioritizing returns over risk.  Picking the best country can usually lead to more outperformance than the best sector.  In fact, one study concluded that if investors care about returns, then the decisions they should spend the most time on are, in order:

  1. Security selection
  2. Country sector selection
  3. Country selection
  4. Global sector selection
  5. Asset allocation

This makes sense, as the dispersion between the winners and losers in each category typically decreases as we move from 1 to 5 on the list.

Yet another study shows that when you account for risk – i.e. looking to maximize risk-adjusted returns – then the decision hierarchy should be reversed.  While this effect was most prominent in the U.S., it still brought security selection and asset allocation to about par internationally.  And, after accounting for transaction costs, it put asset allocation ahead.

As mentioned before, the explicit objective of our Risk Managed Global Sectors strategy is to protect and participate – a dual mandate all about risk-adjusted returns.  And so we believe, that for our objective, global sector ETFs are the best instrument of allocation.

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn.

Corey is a frequent speaker on industry panels and contributes to ETF.com, ETF Trends, and Forbes.com’s Great Speculations blog. He was named a 2014 ETF All Star by ETF.com.

Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University.

You can connect with Corey on LinkedIn or Twitter.