In the jungle of ETFs available, many long-term investors, both relatively seasoned and those newer to the game typically are uncertain what kind of funds they should put the most emphasis on. Especially given the proliferation of sector ETFs, it may have become all too easy to select choices that focus quite narrowly on particular corners within the stock market at the expense of having investments that are invested across a broad spectrum.
Investors should realize that too much focus on specific sub-sectors of the overall market can leave you with a higher likelihood of attempting to manage what may amount to an undiversified portfolio. For most investors, therefore, if you do choose one or more funds to hone in on highly specific subsets of the market, this should be done mainly to supplement your broader-based funds. An over-emphasis on sector funds in effect suggests one is trying to guess which segments of the markets are going to offer the best return, something that is extremely difficult even for investing professionals, as you will see shortly.
It should be remembered that most diversified non-sector stock ETFs or mutual funds, whether index funds or actively managed, already include investments across a wide spectrum of sectors. And among these funds that are actively managed, the manager will already be engaged in selecting those sectors that appear the most promising from his or her perspective.
If you are an investor who likes to do research and follow the markets regularly, then a small to moderate amount of investments in ETFs focusing on specific market niches can make sense if you feel strongly that one or more sectors are likely to outperform. However, the majority of one's portfolio should still remain invested in a few core types of diversified funds as opposed to investing in sectors. These should consist of essentially three main types of stock funds:
All US investors should have at least a moderate amount of money invested in the broadly-defined US stock market. We typically recommend Vanguard S&P 500 ETF (NYSEARCA:VOO). This most basic position should focus on large cap stocks. The second category of stock funds most investors should hold should capture the small/mid-cap stock arena. We like Vanguard's Mid-Cap (NYSEARCA:VO) or Small-Cap (NYSEARCA:VB) offerings. The final category of ownership should involve having at least a small, if not moderate, position in diversified international stocks. Here we typically recommend Vanguard Total International Stock (NASDAQ:VXUS).
Regardless of how these core investments are labeled (for instance, whether all-inclusive index funds, or those labeled "growth," "value," "capital appreciation," "income," etc.), the composition of these primary building blocks of one's portfolio typically should not be extremely slanted to just a few market sectors, such as, for example, technology or financial stocks.
Of course, certain ETFs might combine at least two of these above core components into a single fund. For example, a global fund that invests in stocks from all over the world including the US with typically just large cap stocks, such as Vanguard Total World Stock ETF (NYSEARCA:VT), would be one.
We have already mentioned two commonly classified sectors of stocks: technology and financial stocks. Most lists include the following nine others as well, for a total of 11 stock sectors.
- Consumer Staples (also called Consumer Defensive)
- Basic Materials
- Industrials (also called Capital Goods; sometimes includes Transportation stocks)
- Consumer Cyclical (also called Consumer Discretionary)
- Real Estate (sometimes included under Financials)
- Health Care
If you invest in an S&P 500 index fund such as VOO, you will automatically get a diversified cross-section of investments in all 11 sectors in proportion to how they are approximately weighted in the S&P 500 index. If you invest in an actively managed but diversified fund (non-sector), you are implicitly giving the manager the task of selecting and occasionally modifying his/her picks from among these various sectors.
This, then, should mean you do not need to own any sector funds yourself, except as noted above for perhaps a small proportion of your own stock fund investments. Of course, if one does not have confidence any manager can consistently "beat the market," it would not make sense to invest in a managed fund since you will get the overall market's sector percentages as well as its overall return at a lower cost in an unmanaged index fund.
Examples of Sector Proportions in Three Popular Funds
Let's look at the latest available sector breakdown of the S&P 500 index as well as that of three highly successful managed stock mutual funds. Each of these three funds have outperformed the S&P 500 by an average of nearly 3% per year over the last 10 years (or about 30% cumulatively). The first is considered a mid-cap value fund, the 2nd a large blend fund, and the third a large growth fund.
Sectors as a Proportion of the S&P 500 Index
As you can see, there are big differences between how the funds and the index are invested in all but the smallest sectors. All have a low position (compared to the index) in Financials, Real Estate, Energy, and Utilities while some have a very high position in Consumer Cyclicals, Technology, Consumer Staples, and Health Care.
These choices should give you some clues as to how a few outstanding fund managers are betting on sectors looking forward. (In contrast, my Model Portfolio choices mainly suggest other choices because I think the most currently popular sectors are highly overvalued.) But they also highlight the large differences in sector selection even among the most seasoned and successful managers. Given their prior successes, one might try to follow their lead if you choose to own narrowly focused sector funds. Note, however, that the sector differences between even outstanding funds are generally so large as to suggest one or more of these funds will likely wind up having had, in hindsight, too big a position in underperforming sectors and/or too small a position in overperforming ones. In short, one or more of these sector choices will be wrong, emphasizing just how hard it is for anyone to know in advance which sectors to overweight vs. underweight in a portfolio. Of course, misguesses can hurt forward performance, although underperforming and overperforming sector choices could balance each other out.
While I typically recommend looking for segments of the market that are undervalued, my Model Portfolios in total, have nearly always hewed to portfolios that are not very far from being composed of each of the sectors found in the broad market. Over the last several years, my sector fund choices have averaged only about 15% of the entire portfolio and emphasized Financials, Consumer Cyclicals, and Real Estate. On the other hand, if one's portfolio sector percentages are too much like those found in the S&P 500 index, there would be little point in investing a variety of funds since they will likely perform no better than the index, and possibly worse, while management fees could be higher.
Right now, we are still putting a small overweighting in our Model Portfolios in Vanguard Financials (NYSEARCA:VFH), while adding small positions in Vanguard Energy (NYSEARCA:VDE) and Consumer Staples (NYSEARCA:VDC).
If I haven't already convinced you that sector funds should only take up a small percentage of your portfolio, consider this fact: According to morningstar.com, sector performance results for 14 sector categories over the last 1, 3, and 5 years have only beaten S&P 500 returns over the same periods in 43%, 14%, and 29% of instances, respectively. The 14 categories include all those above but also include Natural Resources, Precious Metals, and "Miscellaneous" sectors.
In other words, generally speaking, investors who included sector funds in their longer-term portfolios had a much reduced chance of lagging a broad-based investment such as the S&P 500 than in exceeding it. These are powerful findings that should argue for typical fund investors keeping their investments in sector ETFs to a minimum.
Disclosure: I am long VOO, VO, VB, VFH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.