Sector ETFs can be used to execute numerous investing views or strategies with comparatively little risk
Passive, market index-based funds have gotten the lion’s share of attention in recent years, but that trend may be set to change as broad equity markets get hammered from resurging volatility. Rather than invest in broad indexes like the S&P 500, for example, equity ETF investors may want to consider more focused strategies, which are possible with sector ETFs.
“The definition of sectors can evolve over time as the economy and companies change, but the commonly used Global Industry Classification Standard (GICS) uses eleven different sectors,” wrote Forbes contributor Simon Moore. “Sector-based Exchange Traded Funds (ETFs) can provide a way to capture opportunity, or control risk, in a portfolio.”
One way to use sector-based ETFs, Moore explained, is to express a view on a sector without picking specific stocks. As an example, someone who believes that energy companies have attractive valuations and are in a state of positive momentum could incorporate a sector ETF into their portfolio, providing a tilt toward that investing theme without the detailed analysis required in active stock-picking. “[B]ecause of how stock returns are distributed, tracking a sector-based index can be a better move than stock picking in some cases,” he added, noting that it’s much less likely for a whole sector to sink to zero than it is for just one stock to do so.
Sector ETFs can also be used to provide valuable risk control. Those who believe forecasts of an impending recession, for example, could load up on sectors such as healthcare, consumer staples, and utilities; because demand for the products from such industries depend less on the state of the economy, they have historically tended to hold up better than the broader stock market.
“It's also possible to include the energy sector as part of this approach,” Moore said, explaining that because of factors unique the sector, it may perform poorly in a strong stock market or do well in a weak one. “It's a source of diversification, but it's likely just less correlated with the overall market than many sectors, but not negatively correlated.”
Finally, sector ETFs could be used to create a portfolio that excludes certain industries. A typical tracker of the US stock market would have significant tech exposure — around one fifth of the S&P 500’s value is in tech, Moore said — but the US tech sector appears expensive based on numerous measures of valuation. To avoid this, an investor could create a portfolio containing all the other sectors, with underweighted or no exposure to technology shares.
“[B]y taking this approach you will increase your expense ratio and reduce your diversification somewhat, but if you are concerned that particular sectors are unattractive, then this approach may be worth considering,” Moore said.
Another risk-management measure, Moore suggested, would be to exclude the industry one works in from their investment portfolio. Assuming that sector does well, that person will likely see a benefit in their paycheque and career prospects, so one can better manage their overall risk across both their investment portfolio and income.
“It is worth shopping around depending on the sector you're most interested in,” said Moore, noting that sector ETFs are typically more costly than broad index funds. “[I]f it's adding to expense ratios and trading costs too, then those additional costs, could outweigh potential benefits.”
