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 an 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), the gross expense ratio for which is 0.14% as of October 2016, versus 0.11% 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 in 1999. As of September 2016, the GICS hierarchy begins with 11 sectors and is followed by 24 industry groups, 68 industries and 157 sub-industries. The other classification, the ICB, was jointly developed by Dow Jones and FTSE. The ICB hierarchy has 10 industries, 19 super sectors, 41 sectors and 114 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.

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 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 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 sector 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.

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