CNBC's Jim Cramer was recently quoted as saying "this should be the beginning of the end for sector ETFs". While I agree with Todd Rosenbluth's initial response on Twitter, I felt it important to lay out a few facts and lists of sector ETFs highlighting why their importance to investors will drive continued growth of these funds. Contrary to Jim's claim that sector ETFs are nothing more than "fee generators", domestic sector ETFs barely charge more than the lowest cost passive trackers that don't provide any sector flexibility, and are only significantly more expensive internationally where they are more needed but less used so far.
One of the biggest pain points facing investors in index funds is sector imbalance. The two most tracked (by assets) index ETF benchmarks in the US are the S&P 500 index, tracked by the SPDR S&P 500 ETF (SPY), and the Nasdaq-100, tracked by the Invesco QQQ ETF (QQQ). SPY currently allocates about 25% to the information technology sector and 12% to financials, while QQQ expressly excludes financials and allocates over 47% to information technology. If an investor wants to reduce exposure to financials or technology, trading between SPY and QQQ would be a very crude way to do so, especially since the latter also screens out names listed on the New York Stock Exchange, and neither helps increase your exposure to mining, energy, of consumer products. Although I like the idea of "just picking the best names in each sector" as much as Jim Cramer does, for sectors investors are not prepared to trade on a name by name basis, there is a real current need for funds that slice the market by sector. Given the rise in commission-free trading and portfolio trading software, I expect investor demand for sector ETFs to correct sector imbalance will rise at least as quickly as ideas like "direct indexing". As I will outline below, the costs of domestic sector ETFs are barely a few basis points more than comparable passive benchmark fees, and these could continue to come down even further with more demand and competition.
Internationally, sector ETFs are, to Jim Cramer's criticism, significantly more expensive, but also significantly more valuable. Many US-based investors don't have easy access to trade foreign securities and foreign exchanges, and the lowest cost passive trackers of foreign markets tend to be heavily overweight financials. For examples the iShares Core MSCI Total International Stock ETF (IXUS) has almost 25% in financials, while the Vanguard FTSE Emerging Markets ETF (VWO) has an even greater 28% in financials. Although I might wish to simply see more international ETFs with reduced or no financial exposure, some of the more expensive sector ETFs listed below are often the next best option for accounts with no direct foreign access.
Below are four lists of major sector ETFs by category, which you can use as a reference to compare against lower cost "passive" benchmarks that don't provide sector flexibility.
Sector ETF List #1: Sector SPDRs
The oldest, biggest, and perhaps best known and traded sector ETFs are the sector SPDRs, launched in 1998 as way of providing slices of the popular S&P 500 SPDR into major sectors. Initially 9, there are now 11 sector SPDR ETFs, ranked by assets under management below.
- Technology Select Sector SPDR Fund (XLK)
- Financial Select Sector SPDR Fund (XLF)
- Health Care Select Sector SPDR Fund (XLV)
- Consumer Staples Select Sector SPDR Fund (XLP)
- Consumer Discretionary Select Sector SPDR Fund (XLY)
- Utilities Select Sector SPDR Fund (XLU)
- Industrial Select Sector SPDR Fund (XLI)
- Energy Select Sector SPDR Fund (XLE)
- Communication Services Select Sector SPDR Fund (XLC)
- Real Estate Select Sector SPDR Fund (XLRE)
- Materials Select Sector SPDR ETF (XLB)
As the below chart shows, the overall trend for the sector SPDRs' assets under management has been steady overall growth, even with a certain degree of sector rotation and performance chasing. At an annual expense ratio of 0.13% for each of these ETFs, compared with 0.0945% for SPY, investors clearly seem to think the additional freedom and flexibility is worth the extra 0.0355%/year.
Sector ETF List #2: Vanguard
If cost is the main criticism of sector ETFs, Vanguard's sector ETFs are slightly cheaper at 0.1%/year for all of the following except for the two real estate ETFs, which charge 0.12%/year. Again, in order of size from largest to smallest as of today:
- Vanguard Real Estate Index Fund (VNQ)
- Vanguard Information Technology ETF (VGT)
- Vanguard Healthcare ETF (VHT)
- Vanguard Financials ETF (VFH)
- Vanguard Global ex-U.S. Real Estate Index Fund ETF (VNQI)
- Vanguard Consumer Staples ETF (VDC)
- Vanguard Utilities ETF (VPU)
- Vanguard Industrial ETF (VIS)
- Vanguard Consumer Discretionary ETF (VCR)
- Vanguard Energy ETF (VDE)
- Vanguard Communication Services ETF (VOX)
- Vanguard Materials ETF (VAW)
While I would love to compare each sector SPDR with its corresponding Vanguard sector ETF head to head, the below two charts will focus on only two comparisons: technology (XLK vs. VGT) and financials (XLF vs. VFH). In both cases, the Vanguard fund outperformed the SPDR since the formers' 2004 launch by far more than just the fee difference, likely due to the Vanguard funds not being limited to S&P 500 components and broader diversification into more small names.
Sector ETF List #3: iShares Global Sector ETFs
Although iShares also has a competitive lineup of domestic sector ETFs, as well as "expanded" and "evolved" sector ETFs, I believe their most unique suite of sector ETFs are their global ones.
As mentioned earlier, international sector ETFs tend to be much, much more expensive than a passive international or global tracker fund, but in many ways may be worth that extra cost for the added diversification and flexibility. All of the below ETFs except for the REIT one, which charges 0.14%/year, charge 0.46%/year.
- iShares Global Infrastructure ETF (IGF)
- iShares Global Tech ETF (IXN)
- iShares Global REIT ETF (REET)
- iShares Global Healthcare ETF (IXJ)
- iShares Global Consumer Staples ETF (KXI)
- iShares Global Energy ETF (IXC)
- iShares Global Clean Energy ETF (ICLN)
- iShares Global Financials ETF (IXG)
- iShares Global Telecom ETF (IXP)
- iShares Global Timber & Forestry ETF (WOOD)
- iShares Global Utilities ETF (JXI)
- iShares Global Consumer Discretionary ETF (RXI)
- iShares Global Materials ETF (MXI)
The significant difference in expense ratios might be best explained by the direct competition between REET and Vanguard's VNQ and VNQI domestic and international REIT ETFs. The other global sectors, on the other hand, are in "Vanguard-free zones", and have not been subject to the "Vanguard effect" pushing down their expense ratios. This is not entirely due to lack of assets, since the largest domestic tech sector ETFs, XLK and VGT, each hold about $26 billion, but the global version IXN still has over $3 billion in assets. This could be seen as one metric of home country bias, which I expect may rebalance if the US underperforms foreign markets for a few years. I also find it interesting that the global sector fund for infrastructure has slightly more assets than technology, and that clean energy has almost as much as energy. As with the sector SPDRs, below is a chart showing the progression of AUM in these sectors over time:
Sector ETF List #4: China Sector ETFs
More specific on the international side, I have long looked for more vehicles for sector specific access to emerging and frontier markets more broadly, and to certain foreign sectors specifically. I most cases though, by the time I get to that level of detail, I will often simply start choosing and trading individual names I rather have than bother paying up for a sector ETF. This is especially true with markets like China, where I have access to directly trade single stocks, but not markets like India, where I do not have such direct access. That said, for a quick view or trade on how the different sectors of the world's second largest market are doing, here is the lineup of China sector ETFs from Global X:
- Global X MSCI China Consumer Discretionary ETF (CHIQ)
- Global X MSCI China Financials ETF (CHIX)
- Global X MSCI China Communication Services ETF (CHIC)
- Global X MSCI China Real Estate ETF (CHIR)
- Global X MSCI China Information Technology ETF (CHIK)
- Global X MSCI China Health Care ETF (CHIH)
- Global X MSCI Consumer Staples ETF (CHIS)
- Global X MSCI China Industrials ETF (CHII)
- Global X MSCI China Materials ETF (CHIM)
- Global X MSCI China Utilities ETF (CHIU)
- Global X MSCI China Energy ETF (CHIE)
As in any other market, you would expect to see leading and lagging sectors over time. Below charts the past 5 years' performance of CHIQ (consumer discretionary) and CHIX (financials) versus the iShares MSCI China ETF (MCHI):
Until direct indexing makes it easier for investors to more directly manage sector imbalances and tilts versus the major "one size fits all" index benchmarks, sector ETFs have a significant role to play in portfolios, especially internationally. While I have already explained why I prefer buying a sensible and balanced portfolio of individual stocks over any S&P 500 index fund, and especially for my kids, I know that for many investors, shorting a few shares of XLK or buying a few shares of XLRE may be a simpler and cheap enough way to restore some sector balance to their portfolios.
This month in Long Run Income, I am taking a closer look at many of the top components of the S&P 500 and other index funds to see which are robust enough to increase your retirement income over the next 10-30 years. Get inspired with your free trial to Long Run Income.