Dilution of Sector Exposures: When Does Unintended Indexing Happen?

Michael Stein and Svetlozar T. Rachev

Volume 12, Number 3, Third Quarter 2014

We analyze how the inclusion of several sectors in a portfolio leads to a countering of exposures and to a replication of the index. Using a weight-based measure, we find that on a composition level unintended indexing appears to happen with only moderate severity. However, co-movement with the broad index as measured with standard techniques is a result that is found at already small numbers of included sectors. The results found are robust over time and market phases. We show that investors to sector exchange-traded funds should carefully select the number of investments and base this on the resulting exposure rather than on portfolio-weighting observations. Otherwise, their sector bets or selections are diluted by unintended indexing.