What Are They?
- Sector ETFs give you exposure to an entire sector, rather than more specific targeting of sub-sectors and or narrow themes within the sector. For example, a sector ETF is "Technology", not "Software" and not "Enterprise Software".
- Most sector ETFs are market-cap weighted, meaning that larger companies have greater representation in the index, and if a stock's price rises fast, its weighting in the index rises. Equal weight ETFs contain equal dollar amounts of each stock and therefore need to be rebalanced periodically.
- Leveraged and leveraged inverse ETFs use options and futures contracts rather than stocks. Any funds not invested in them are deposited in a money market account or invested in bonds.
- Quant strategy sector ETFs provide exposure to US sectors via a basket of stocks determined by rules-based quantitative analysis, such as "overweight stocks with low P/E ratios" or "overweight stocks that have beaten earnings estimates for three quarters running".
Why & How To Use Them
- There are three ways to use sector ETFs: (1) for short term trading, (2) to overweight one or a couple of sectors in a long term portfolio by adding a single sector ETF to a portfolio of broader ETFs, or (3) as the basic building blocks of a long term portfolio.
- The argument for using sector ETFs as the basic building blocks of a portfolio is that doing so makes your portfolio more granular, providing more rebalancing opportunities. Since most stock market bubbles are led by individual sectors (think tech in 1999, financials in 2008), rebalancing between sectors may afford protection and greater returns.
- Sector ETFs are attractive to short term traders and momentum investors, as there are dramatic differences in the performance of US sectors in most years.
- Sector ETFs are good for hedging. Hedge funds can use them to hedge long positions concentrated in a particular sector, and sophisticated individuals can use them to hedge job exposure.
- Active traders can use leveraged ETFs to play short-run market movements. Since they have more volatility than a regular index fund, the potential for gain (and loss!) is larger.
- Use the quant strategy ETFs instead of regular index sector ETFs if you believe that quantitative, rules-based stock selection will outperform a market cap weighted or equal cap weighted index.
What to Look Out For
- Compared to broader index ETFs, sector ETFs tend to have higher expense ratios and wider buy-sell spreads (which makes them more costly to purchase and sell).
- Market-cap weighted sector ETFs tend to be dominated by large cap stocks, so they don't provide much exposure to small cap stocks. The dominance of large cap stocks also leads to concentration, making them generally more volatile than broader index ETFs.
- If you're using sector ETFs as the basic building blocks of a long term portfolio, don't mix families. For that reason the sector ETFs are grouped together on this page by index family.
- Foreign sector ETFs provide varying degrees of exposure to currency movements, and it's not always easy to assess that exposure. The dollar value of foreign stocks is directly impacted by currency movements -- after all, they're priced in a foreign currency. But currency movements also impact sector earnings depending on how export oriented the sector is and the degree to which its costs are priced in foreign currency, and earnings can impact stock prices.
- Leveraged sector ETFs are riskier and more volatile than standard sector ETFs. They tend to have higher expense ratios than standard sector ETFs, even proportionate to the level of exposure. Also, the use of futures means that dividend income would be lower or non-existent. Leveraged ETFs perform poorly in flat markets, and can underperform their benchmarks in conditions of significant volatility.
- Compared to broader index ETFs, specialty ETFs such as equal weight ETFs and quant strategy sector ETFs, tend to have higher expense ratios and wider buy-sell spreads (which makes them more costly to purchase and sell). The quarterly recalibration of the stock baskets underlying these ETFs leads to higher stock turnover and therefore potentially higher trading costs and lower tax efficiency.
- Track sector performance on Seeking Alpha's Sectors data dashboard.
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.