Sector ETFs bring additional strength to the individual investor’s portfolio, allowing for further diversification and strategic possibilities. Companies have long been classified into industries based on their primary business goals. The reason for this is self-evident. Businesses that operate in synonymous sectors of the economy will often encounter similar problems as well as opportunities, and will often be collectively impacted by changes in the economy. These external factors make for some ripe investable opportunities.
Investors are increasingly attracted to sector ETFs, which can be used to both hedge and speculate, largely due to their great liquidity and opportunities for specialized investing. This article delves into the details of sector ETFs, their advantages and disadvantages, and how to incorporate them into your investment strategy. But first…
- What is a Sector ETF?
- Why invest in sector ETFs?
- Is there a downside to Sector ETFs?
- Increased volatility
- Reduced fund-level diversification
- How to incorporate sector ETFs into your portfolio
- So, are sector ETFs a good investment?
What is a Sector ETF?
An ETF (exchange-traded fund) is a pooled investment vehicle that tracks an index, commodity, bond, or asset portfolio, such as an index fund, and can be traded on a stock exchange just as regular stocks can.
A sector ETF is an ETF that tracks and invests solely in the stocks and securities of a specified industry or sector. Rather than tracking the broad market as a whole, sector ETFs allow you to invest in a small portion of the market, such as real estate, energy, health care, or technology, for example.
While many of these tightly targeted ETFs have the potential for significant growth, you should also expect to experience substantial swings in the value of your investments and prepare yourself for the event of large losses.
Typically, the sectors are subdivided into categories. Within each market, different subsectors can be further defined. The Global Industry Classification Standard (GICS) is the international standard for determining company classifications in the financial sector. There are various ETFs that track the benchmark indices in these industries.
The GICS was created by index providers such as MSCI and Standard and Poor’s. The GICS hierarchy starts with 11 sectors: Energy, materials, financials, industrials, healthcare, real estate, consumer discretionary, consumer staples, information technology, communication services, and utilities.
There are then a further sub-categorized 24 industrial groups, 68 industries, and 157 sub-industries that they can be divided into. Regardless of size or distinctive qualities, all stocks on Wall Street fall into one of these groups.
Why invest in sector ETFs?
Sector investing via ETFs can be a great diversifier. Globalization has increased the correlation between local and international stocks, and now large, mid, and small-cap companies are highly connected. The performance of a business is now determined more by its industry than by its market capitalization or location.
Sector investing has therefore been considered an excellent tool for fine-tuning a portfolio to an investor’s personal risk tolerance. A conservative investor may favour utilities, which is a less volatile industry, whereas a more active investor might favour technology, considered one of the most volatile.
Rather than purchasing individual stocks within a sector, investors can purchase the entire sector, minimizing company-specific risk.
By purchasing a single sector ETF, you can acquire instant, cost-effective exposure to a portfolio of shares in a specific industry area. Manually compiling a pool of stocks from individual securities in a particular industry, on the other hand, would take a long time.
An ETF tracking the MSCI World Health Care index, for example, follows the health care industry in Developed Markets around the world. Pfizer, Roche, and Johnson & Johnson are among the top holdings.
Before the emergence of sector ETFs, gaining exposure to specific sectors would have meant either buying stocks individually (involving more cost and risk because you’re picking single stocks) or investing in an actively managed fund for that sector (which would entail high annual fees and put your investments at risk of underperforming).
Additionally, some sector specific ETFs target very niche parts of the market. For instance, instead of (or in addition to) investing in a larger technology sector fund, an investor can enhance their exposure to a specifically targeted ETF, such as an artificial intelligence ETF.
Is there a downside to Sector ETFs?
An ETF that tracks a specific sector, such as an oil services ETF, can fluctuate dramatically and experience more price volatility than a broadly diversified sector ETF, such as the S&P 500.
Reduced fund-level diversification
Even though sector funds might own dozens or hundreds of securities that potentially enhance portfolio diversification, investors still face inadequate diversification at the fund level.
How to incorporate sector ETFs into your portfolio
If you want to follow the sector route when diversifying your portfolio, look at the breakdown of industry sectors and make sure you can allocate funds to all or almost all of the economy’s major sectors.
You may already have exposure to your sector of interest if your current portfolio is already well-diversified. Increase your exposure to narrowly specialised sectors only if you’re comfortable with the extra risk, can afford it financially, and are emotionally prepared to face swings and losses.
It’s a good rule of thumb that no single sector should ever account for more than 20% of your stock portfolio, regardless of how popular it is at the given moment.
Start by allocating roughly according to each sector’s market capitalization, and then tune from there – based on the specific characteristics of each sector, as opposed to wishful predictions of the future.
If you’re hesitant about the increased risk and volatility that often accompanies sector ETFs, consider adding funds that provide broad coverage of the major industries. The Health Care Select Sector SPDR ETF (XLV) is the largest healthcare sector fund, with $33 billion in assets under management. It’s a targeted but diversified alternative for investors looking to play a sector that can rely on plenty of clients even during unpredictable economic conditions.
So, are sector ETFs a good investment?
Sector ETFs give investors concentrated exposure to a specific stock market industry or sector. While investing in a sector ETF can help with portfolio diversification, excessive exposure to one sector can raise risk and volatility when compared to investing in an ETF that tracks a broad market index, like those that track the MSCI or S&P 500.
Keep a close eye on more exotic or narrow sector ETFs, as they may have a tiny number of assets under management, resulting in greater fees. Your best option is to invest in sector ETFs that provide a diversified mix of securities in a single fund, such as the Vanguard Information Technology ETF (VGT).
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