Sector ETFs or a Broad Market Index?

Why would someone rationally choose to invest in one or more sector ETFs, instead of a broad market index? And, having decided to invest in a sector, which ETF product should they use?

Let's start with the three main reasons an investor might want to use a sector product instead of a broad market index. In Bill Sharpe's Princeton lectures, he succinctly summarized these as differences in position, preference, and prediction.

Position refers to the basic economic circumstances facing an investor - think of it as his or her cash flow profile and/or liability structure. To the extent an investor's position differs from that of the average (market index owning) investor, he or she may prefer to use one or more sector index products. Examples of these differences include investors with large equity exposure to private businesses or restricted stock, or whose family income comes from a single industry.

Different preferences are typically take to refer to investors aversion to risk and uncertainty. However, I consider this a weak argument, as an investor can just as easily adjust his or her portfolio exposure by varying asset class weights as by varying sector weights within the equity asset class. On the other hand, there are stronger arguments for preference differences in the area of taxes, where investors may differ in their willingness to realize losses via transactions that utilize ETFs.

Finally, the most commonly noted difference between investors is in their respective predictions about future risks and returns, and the extent to which they believe they either have or can access superior insights that will translate into index-beating after tax, risk adjusted returns. In this area, however, investors should be aware of our all-too-human tendency to be overconfident about our relative abilities.

In sum, there are clearly logical reasons that an investor might prefer to use sector ETFs rather than a broad market ETF.

Having decided to invest in one or more sector ETFs, how can one choose between them? In general, we look at two issues: the breadth of the index tracked, and the costs involved in owning and trading the ETF. Broadly speaking, domestic ETFs based on Dow Jones (iShares) and Morgan Stanley Capital International (Vanguard) indexes are broader based than those based on Standard and Poor’s Indexes (SPDRs). However, iShares also offers a limited number of ETFs that are based on very broad Standard and Poors global sector indexes. However, these products also contain country and currency risks, so they are not perfectly comparable to the purely domestic sector ETFs.

The costs that investors pay to use different sector index products can be divided into their explicit expenses, and indirect costs (e.g. market impact) that are related to the liquidity in the market for the specific ETF. The Vanguard and SPDR sector ETFs generally have lower expenses than the iShare products; when it comes to liquidity, the SPDR products currently have the edge. In sum, there is no clear winner among the three major product family alternatives for investors interested in sector ETFs.

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Comments

[Tom Kasperski:]

You're comparing completely different strategies...apples vs. oranges. Also, I would doubt many investors who practice an active sector rotation strategy would use something other than a tax deferred/exempt account.

2006 Sep 22 09:25 AM