The proliferation of sector exchange traded funds (ETFs) has made it easier than ever for investors to implement sector-related strategies. Having more choices, however, means having to implement more analysis to assure that you are choosing the correct ETFs for your own strategy. This article will outline the basic types of sector ETFs and some advantages and disadvantages of each type to give you an idea of how you might best use this investment vehicle.

SEE: Sector Rotation: The Essentials

Why Invest in Sector ETFs?
The use of sector ETFs provides instant diversification, reducing the risk compared to purchasing individual stocks. For example, purchasing an energy-sector ETF will allow an investor to make a bet on energy prices better than buying one or two energy stocks. Many investors take a top-down approach, and make their decision based on an underlying trend in the economy. A sector ETF will allow them to capture that trend efficiently, without worrying about selecting stocks in that sector.

The Pros
The advantage of using sector ETFs as the building blocks of a portfolio is that they can provide for finer tuning of a portfolio versus a broad-based ETF. The process of selling those sectors that have outperformed and buying those that have underperformed - a sell high, buy low strategy - can improve performance. Using sector ETFs will allow you to avoid or minimize those which are overvalued. As an example, in the technology stock bubble of 1999-2000, the S&P 500 was overly concentrated in technology stocks. Building a portfolio of sector ETFs versus a S&P 500 ETF would allow the investor to have reduced their exposure to technology stocks.

The Cons
Using sector ETFs comes with some drawbacks. The expense ratio tends to be more expensive for sectors versus the broad-based ETFs of which they are a part. For example, let's take a look at Consumer Staples Select Sector SPDR ETF (ARCA:XLP) , which charged 0.18% per year, versus 0.10% for the State Street SPDR S&P 500 ETF (ARCA:SPY). Using sector ETFs will result in greater trading costs as the bid-ask spread widens on the more thinly traded sector ETFs. Because there are more sectors, the total cost of trading will rise as more trading will be required.

Sector Classification
The key to understanding the use of sector ETFs is to understand the how stocks are classified into different sectors.

The two main classification schemes are the Global Industry Classification Standard (GICS), and the Industry Classification Benchmark (ICB). The GICS was developed by Morgan Stanley Capital International (MSCI) and Standard & Poor's. The GICS hierarchy begins with 10 sectors and is followed by 24 industry groups, 67 industries and 147 sub-industries. The other classification, the ICB, was jointly developed by Dow Jones and FTSE. The ICB hierarchy has 10 industries, 18 super sectors, 39 sectors and 104 subsectors. In general, the schemes are very similar, although there are some minor differences. The chart below shows which sectors makes up each classification scheme.

Sector Classification Schemes
Sectors GICS ICB
Consumer Discretionary X --
Consumer Stables X --
Consumer Goods -- X
Consumer Services -- X
Energy X X
Financials X X
Health Care X X
Industrials X X
Information Technology X X
Telecommunications X X
Materials X X
Utilities X X

Types of Sector ETFs
As the number of ETFs offered has exploded, so has the number of ETFs dedicated to sectors. There are now ETFs in some very specific sectors and industries such as environmental services, Internet, building and construction, leisure, biotechnology and homebuilders. They are useful, especially for those who use them instead of buying individual stocks. However, for those interested in building a portfolio using all sectors, it is better to focus on those families of sector ETFs that cover the full universe of stocks that make up a specific index. These will be discussed below.

Market Weight Sector ETFs
Market weight sectors are based on the traditional market capitalization indexes and their underlying sectors. Two of the largest families of sector ETFs are the Barclays iShares Dow Jones Sector ETFs and the State Street Global Advisors Sector ETFs. They each will cover the full universe of stocks that are in the respective indexes they track.

Market weight sector ETFs provide excellent exposure to the overall U.S. market. They are essentially biased towards to large cap stocks, not providing much exposure to small cap stocks. Market weight sectors can also result in concentration among a few stocks in each sector. Although an investor can use different sector ETFs to create a portfolio, it is important not to mix the families.

State Street Select Sector SPDRs uses the S&P 500 as the underlying index, which includes the 500 leading companies in the U.S. It is a market capitalization index representing about 75% of the U.S.equity market. The Sector Select ETF uses the GICS to determine the composition of each sector. Although there are 10 sectors, there are only nine ETFs, as the information technology and telecommunications sectors are combined to create one sector called technology.

Equal Weight Sector ETFs
"Equal weight" means that all stocks have a similar weighting in the index, regardless of the company's size. In an equal weight index, each stock has the same impact on the overall performance of the index. In a market weight index, the large cap stocks have a greater impact than the small cap stocks. Therefore, an equal weight index will outperform a market weight index when small cap stocks are outperforming large cap stocks.

Each sector ETF is rebalanced quarterly to maintain an approximately equal weighting among all stocks. This is essentially a buy low, sell high strategy as shares in those stocks that have outperformed will be sold and shares in those companies that have underperformed will be bought. It is important to note that more rebalancing will lead to higher transaction costs and lower tax efficiency, since the stocks with the greatest gains have to be sold, triggering capital gains.

An example of this type of ETF is the Guggenheim S&P 500 Equal-Weight Sector ETF (ARCA:RSP), which is based on the S&P 500 index and the GICS. Rather than using the 10 main sectors, they will use only nine, combining information technology and telecommunications into one sector called technology.

Fundamentally Weighted Sector ETFs
Fundamentally weighted indexes are a relatively new type of index. Rather than being based on the market cap or equal weight, the weighting of each stock in the index will be based on the underlying fundamentals.

When market weight indexes are used, they tend to give greater weight to overvalued stocks compared to using the underlying fundamentals. Consequently, fundamentally weighted indexes have a greater value tilt than the market weighted indexes. Fundamentally weighted indexes are also weighted towards large companies over small companies.

As the underlying price and fundamentals change, the fundamentally weighted ETF will have to regularly buy and sell stocks. This leads to higher portfolio turnover, resulting in potentially higher trading costs and lower tax efficiency.

PowerShares has created a series of sector ETFs based on a fundamentally weighted sector index. They are based on the FTSE RAFI US 1000 Index. FTSE is an independent company owned by The Financial Times and the London Stock Exchange. RAFI stands for Research Affiliates Fundamental Index. The FTSE RAFI U.S. 1000 index will consist of the 1,000 U.S.-listed companies with the largest RAFI fundamental values. The factors that determine the fundamental value are sales, cash flow, book value and dividends. Those companies that are deemed the largest by those underlying factors will have the largest weights in the index.

Leveraged Sector ETFs
Leveraged ETFs provide another way to get exposure to an entire U.S. equity sector. However, unlike other sector ETFs, which track an index, the leveraged sector ETFs provide a greater exposure to changes in price and volatility of an underlying index. For example, a sector index that moves up 1% would result in the corresponding leveraged sector ETF going up 2%. Similarly, if an index dropped by 1%, the leveraged ETF should drop by 2%. They also differ from other sector ETFs in that they will not own underlying stocks but use options and futures contracts to provide the leverage.

Leveraged ETFs are useful for playing short-term market movements more effectively than regular ETFs. They allow investors to increase exposure to a sector without needing to borrow money. They can be purchased in retirement accounts that do not allow margin lending.

However, leveraged ETFs have higher expense ratios than standard ETFs, proportionate to their exposure. The use of futures and options means that dividend income will be lower or nonexistent compared to regular sector ETFs.

PowerShares Ultra Sector ETFs are based on the Dow Jones U.S. index. The Dow Jones U.S. index is a market capitalization weighted index designed to represent 95% of the U.S. equity market. The ICB is used to determine the composition of the sectors.

The Bottom Line
Although there are many different types of sector ETFs, those interested in building a portfolio using sectors ETFs as building blocks should focus on those families of ETFs that cover the full universe of sectors that make up the underlying index. Lastly, each investor should also consider the underlying index and weighting scheme that is used to create the ETF before implementing them into a strategy.

Related Articles
  1. Mutual Funds & ETFs

    ETFs Vs. Index Funds: Quantifying The Differences

    If you are trying to choose between these two index-tracking investments, compare the costs.
  2. Mutual Funds & ETFs

    Exchange Traded Notes: An Alternative To ETFs

    ETNs offer yet another way to track an index. Find out what they have to offer, and what's at stake.
  3. Mutual Funds & ETFs

    5 ETFs Flaws You Shouldn't Overlook

    Despite their popularity, exchange traded funds have some drawbacks that investors should know about.
  4. Mutual Funds & ETFs

    Advantages And Disadvantages Of ETFs

    You've probably heard that ETFs are better than mutual funds, but you need to consider all aspects before investing.
  5. Mutual Funds & ETFs

    4 Ways To Use ETFs In Your Portfolio

    To take full advantage of these vehicles, you need to know how they can fulfill certain strategies.
  6. Mutual Funds & ETFs

    3 Steps To A Profitable ETF Portfolio

    Achieve your investing goals with this simple process.
  7. Options & Futures

    The Benefits Of ETF Investing

    Exchange-traded funds provide unique opportunities for investors. Find out how.
  8. Economics

    India: Why it Might Pay to Be Bullish Right Now

    Many investors are bullish on India for all the right reasons. Does it present an investing opportunity?
  9. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  10. Products and Investments

    There's a Reason They're Called Junk Bonds

    The closing of Third Avenue Managemet's Focused Credit Fund is a warning to investors and advisors. Beware the junk.
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. Am I losing the right to collect spousal Social Security benefits before I collect ...

    The short answer is yes, if you haven't reached age 62 by December 31, 2015. The Bipartisan Budget Act of 2015 disrupted ... Read Full Answer >>
  3. What is the maximum I can receive from my Social Security retirement benefit?

    The maximum monthly Social Security benefit payment for a person retiring in 2016 at full retirement age is $2,639. However, ... Read Full Answer >>
  4. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  5. Where else can I save for retirement after I max out my Roth IRA?

    With uncertainty about the sustainability of Social Security benefits for future retirees, a lot of responsibility for saving ... Read Full Answer >>
  6. Will quitting your job hurt your 401(k)?

    Quitting a job doesn't have to impact a 401(k) balance negatively. In fact, it may actually help in the long run. When leaving ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center