Exchange traded funds were designed to help investors by lowering fees, allowing intraday trading, and by providing instant diversification in one investment. The business has since evolved into a trillion dollar industry that has sliced and diced the stock market in every way imaginable.
Sector investing with ETFs is one of the most convenient, and simple ways to gain exposure to an entire slice of the stock market. For example, an investor that wants exposure to the technology sector can do so with a one-stop transaction, while gaining exposure to multiple tech-related companies in one fund. An ETF also cuts the risk factor down, so that all bets are not placed with one company or stock. Furthermore, sector investing should simplify the otherwise complicated decision of what stock to pick, and invests in a number of them.
The question then become which sector ETF should an investor choose? The proliferation of the trillion dollar ETF industry is both a boon to investors, yet a burden. For instance, there are several technology sector ETFs to pick from, all from various providers and with varying degrees of risk and expenses. The index weighting methodology is also another complicated factor, but one that carries an impact. The way an index is modeled impacts cost, company and asset class exposure.
"You can't just pick the largest or the cheapest or the oldest ETF," Todd Rosenbluth, ETF analyst with S&P Capital IQ said. "You have to know what's inside and how what's inside fits with your investment goals."
When an investor is trying to choose from several ETFs tracking the same sector or slice of the market, there are some guidelines to help strengthen the decision-making process, reported by Jonnelle Marte for The WSJ.
- Index Methodology: The majority of ETFs are market-cap weighted, so the biggest, most successful companies represent the largest portion of the index. While large-cap stocks tend to be issued by more mature companies with stable earnings and are easier to buy and sell, more volatile small-cap shares may have stronger growth potential, says Rosenbluth. This can result in over-allocation to just a few of the largest companies. An equal-weight strategy is another option, where every stock represents the same amount of the index, say 5%. This avoids too much exposure to downside risk, and avoids over concentration to the large-caps.
- Asset Count: Of the 1,4000 ETFs trading, about half of the sector funds have garnered $50 million or less. This is the bare minimum to keep the fund profitable, and liquid, and anything lower is considered a danger sign or a means for the ETF to close. Assets are important because they affect liquidity and the bid/ask spread, and will determine if an investor can sell the ETF when the time comes.
- Cost: Cost or expense ratio is important, especially in this fee-based climate. The more fees or the higher the expense ratio, the more it will drag on overall performance and cut into principle. Actively managed ETFs and those that employ a special indexing methodology are more expensive than the average sector ETF. And those that track a small, specialized slice of the market are also costly.
There are sector funds from various providers,so it is essentially up to the investor to do the research and homework needed to find the right match based on risk tolerance and investment goals. The most popular of the sector ETFs are from State Street Global Advisors, which offer the SPDR family of funds. The SPDR Financial Select Sector Fund (NYSEARCA:XLF), SPDR Technology Select Sector Fund (NYSEARCA:XLK) or the SPDR Materials Select Sector Fund (NYSEARCA:XLB) all offer high liquidity and low expense ratios with good diversification benefits.
Tisha Guerrero contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.