This is an article from Motley Fool about sector ETFs. The general tone of the article is that sector ETFs are more volatile and that most investors probably do not need to use these funds, writes Roger Nusbaum.
The author then cites some long standing truisms about sector funds and chasing heat and so on.
While I believe that new investors need to see this kind of commentary to learn about the downside to sector funds, how about some content about a constructive way to use them beside speculating on a sector?
For my job, I do use ETFs in certain situations. A common circumstance where I would use ETFs came up just yesterday for a new client. The client is about my age has just under $200,000 in a couple of retirement account that we are able to access and where the retirement plan allows for stocks, ETFs and anything else offered by the brokerage firm that administers the plan. The asset allocation is 80% stocks and 20% bonds. So that leaves $160,000 to go to equities. This type of amount usually calls for a blend of stocks and ETFs.
I try to use ETFs to replicate, as best I can, the all equity portfolio I have for most clients. I do use sector ETFs in this strategy. For example I am underweight the financial sector. Its weight in the SPX is about 20%. The weight I have for clients is closer to 15%. So one way to go would be to put 15% of the equity portion of the portfolio into one of the financial sector ETFs. Remember though I am trying to get as close to replicating the full equity portfolio. Long time readers know that in the financial sector I own a lot of foreign banks that have high yields and low betas. So maybe instead of 15% into one ETF I will put 10% of the equity portion into the financial ETF and 5% into one of the foreign bank stocks that everyone else owns.
To take it a little further lets say I want to add the EWA I have written about to this account. EWA has about 28% financial exposure so that needs to factor in too. I might want 4% to go to EWA. That means another 1% (from EWA) is added the financial weighting so I need to shave either the financial ETF or the individual stock by 1% to adjust for the financial weight coming from EWA.
So now maybe it looks like 10% in the financial sector ETF, 4% in the individual foreign bank stock and 25% (ish) of the EWA holding counting toward the financials weighting of the entire account.
This, or something like it, gets done for each sector. I am very unlikely to use an ETF for the telecom sector. I rely on this area for a lot of yield, much more than can be had from an ETF. Depending on the volatility tolerance of the client I will, for a given sector use just an ETF, a blend of stock and ETFs or just stock.
In doing this I will have 20-25 transactions to implement an account as opposed to 45. I expect these smaller accounts to lag a little but over time there will be given periods where these accounts will out perform.
After re-reading this post I can see where it might be tough to follow so feel free to email with questions.