When exchange traded funds (ETFs) burst onto the investment scene more than two decades ago, the primary intent, at least for equity-based strategies, was to give investors liquid, low-cost exposure to widely followed broad market benchmarks such as the S&P 500 and the Russell 2000 Index.
It took a few years, but ETF issuers eventually realized the growth potential in marketing sector ETFs to investors. The S&P 500 is now comprised of 11 sectors. In order of weight from largest to smallest, those sectors are technology, financial services, healthcare, consumer discretionary, industrials, consumer staples, energy, utilities, real estate, materials and telecommunications.
Hundreds of Choices
There are now hundreds of sector ETFs from scores of issuers available to investors. Today's sector ETFs run the gamut from traditional to smart beta offerings. Traditional sector ETFs would be cap-weighted strategies such as the Technology Select Sector SPDR (XLK). As is the case with cap-weighted broad market ETFs, a sector fund that adheres to the same methodology will usually feature that sector's largest stock as its biggest holding.
So most cap-weighted tech ETFs will feature Apple Inc. (AAPL) as their largest holding while most consumer staples ETFs will show Procter & Gamble (PG) as the top holding and so on throughout the various sector ETFs.
Buy with Conviction
Sector ETFs are useful on multiple fronts. For example, they allow investors with a strong conviction about a particular sector to gain exposure to that group without having to pick individual stocks. Think about the scenario this way: Even for professional investors, it is far easier to identify a sector that is about to soar or stumble than it is to identify which stocks will cause that sector to rise or fall.
Additionally, sector ETFs allow investors to overweight sectors as they fit, a strategy that can be used in conjunction with broad market ETFs. Say an investor owns an S&P 500-tracking ETF but wants to boost her consumer discretionary exposure. She can add the Vanguard Consumer Discretionary ETF (VCR) to her portfolios.
ETF issuers have responded to investors' increased demand for sector exposure. Today, there are nearly 500 sector ETFs trading in the U.S., a group that includes a lineup of small-cap sector ETFs from one issuer and a stable of newly minted dedicated mid-cap sector offerings from another sponsor.
Underscoring the popularity of sector ETFs, the two largest such funds, the Vanguard REIT ETF (VNQ) and the Financial Select Sector SPDR (XLF), have almost $59 billion in combined assets under management.
Within the universe of sector ETFs are industry funds and investors should be aware of the differences between these two groups. Technology, financial services, healthcare, consumer discretionary, industrials, consumer staples, energy, utilities, real estate, materials and telecommunications are the 11 GICS groups as defined by Standard & Poor's.
Industry ETFs are more focused plays on the various sectors. For example, biotech ETFs would be considered industry funds. Likewise, an aerospace and defense ETF is not a true industrial sector ETF, but it is a derivative play on the broader industrial sector.
Investors should also consider the differences in the structure of even the most basic sector ETFs. For example, the Financial Select Sector SPDR is the largest financial services ETF by assets, but not in terms of number of holdings. XLF holds 67 stocks from that sector, but the Vanguard Financials ETF (VFH) has almost 400 components.
Over longer holding periods, differences like that can lead to varying returns among sector ETFs from rival issuers.
Investors can also consider more sophisticated smart beta sector strategies that range from equal-weight to ETFs that are weighted based on value and growth factors. These products can, in select time frames, outperform their cap-weighted peers, but usually carry higher annual fees.