ETF Investing Guide: Should You Use Sector ETFs?

by: David Jackson

The advantages of portfolio rebalancing - risk reduction and adoption of an automated mechanism for buying low and selling high - should increase in line with the number of asset classes in your portfolio.

If you have only 2 asset classes (such as one “total market” stock index ETF and one bond index ETF) you’ll have less rebalancing to do than if you use the 5 ETF Low-Maintenance Portfolio, which in turn will offer less rebalancing opportunity than the 10 ETF Core ETF Portfolio. And that portfolio would in turn require less rebalancing - and would therefore benefit less from rebalancing - than a portfolio built from ETFs that represent each US industry sector.

Building a portfolio of sector ETFs certainly has some strong attractions. Consider the S&P 500 as an example. Much of the run up in the S&P 500 Index during the bubble was due to the rapid appreciation of large cap tech stocks included in the index. This meant also that the S&P 500 as an index became more concentrated in technology, as it’s a market-cap-weighted index. To make things worse, the S&P committee that selects stocks for the index chose to add tech stocks to the index during the bubble, and drop “old economy” stocks. (The criterion for inclusion is “leading companies in the leading industries”.) Portfolio rebalancing would have encouraged you to do the opposite: trim your position in tech stocks and add to your position in “old economy” stocks. With a 2 asset portfolio - a stock index ETF and a bond index ETF - you would have sold some of the stock ETF and increased your position in the bond ETF. But what you really wanted to do was to sell only tech stocks, and increase your position in bonds and maybe some “old economy” stocks. If your portfolio was constructed from sector ETFs, you would have been able to do this.

While a more granular portfolio provides greater opportunity for rebalancing, however, there are 5 trade-offs:

  1. The expense ratios of the ETFs tend to climb as the ETFs become more granular (Select Sector SPDR ETFs charge 0.28% per year, versus 0.09% for the Barclays S&P 500 ETF).
  2. The bid-ask spread widens if the ETFs are more thinly traded (which is true of sector ETFs vs. the S&P 500 ETFs, for example), so you pay more to trade.
  3. Your online brokerage trading fees rise the more you trade.
  4. The narrower the ETF, the more additions and deletions to the index are likely as a percent of the total, leading to potentially higher capital gains distributions.
  5. More rebalancing means more work.

As a result of these costs, I avoided sector ETFs in the core ETF portfolio outlined so far. Instead, the US stock portion of that portfolio was represented by a large cap index (S&P 500 or Russell 1000), a mid cap index (S&P 400 or Russell Mid-Cap index), and a small cap index (S&P 600 or Russell 2000). The S&P 500 has become far more “balanced” as the bubble has unwound. Currently, the largest potential distortions, according to some, are an under-weighting of technology and an over-weighting of financials. But even according to these critics, the current mis-weightings are nothing compared to the over-weighting of technology during the bubble.

Sector ETFs may prove worthwhile if you are managing a large account, you don’t mind the extra work, and you judge that the benefits of more granular rebalancing will outweigh the larger trading costs, annual expense ratios, and capital gains distributions.

If so, you can find information on sector ETFs at SPDR and Barclays' iShares. The first site provides information about “Select Sector Spiders”, nine sector ETFs that together comprise the S&P 500. The annual expense ratios are 0.28% for each ETF. The second site provides information about fourteen ETFs that track each of the Dow Jones industry classes of the US market. The annual expense ratio on these ETFs is 0.6%. If you decide to use sector ETFs, don’t mix ETFs from these two families, as they overlap due to their different definitions.

Whichever rebalancing trigger and portfolio granularity you chose, rebalancing adds a margin of safety to your portfolio that you would not otherwise have. And rebalancing is extremely easy using ETFs in an online brokerage account. You can buy and sell ETFs easily and cheaply, and you can set Good ‘til Cancel limit orders to sell if prices rise to a certain point or buy if prices fall. With index mutual funds, in contrast, you can’t use limit orders, and you face many of the same problems outlined in the discussion about tax-loss selling.

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