Investors and economists have long grouped companies according to the industry sector the firms are most exposed to.The reason is obvious. Companies operating in similar areas of the economy will typically face similar opportunities and challenges, and are also likely to be impacted as a group by developments in the economic cycle.
A car manufacturer might produce superior vehicles or be more efficiently run than a rival, for instance. But external factors such as new government regulations, a rise in raw material costs or a recession will hit all carmakers to some degree.
Why invest in sector ETFs
Sector ETFs make such observations investable. They enable you to gain instant exposure to a basket of stocks in an industry sector via the purchase of a single ETF.For instance the db x-trackers MSCI World Health Care Index ETF tracks the health care sector of developed markets worldwide. Top holdings include Johnson & Johnson, Novartis, Pfizer, and Roche.
To gain exposure to this sector before the advent of sector ETFs, you would have had to purchase these stocks individually (which would be costlier to implement and riskier because you're picking individual stocks) or else put money into an actively managed healthcare fund (where you will pay higher annual fees and risk underperformance due to poor fund manager decisions).
In contrast today, with sector ETFs, anyone can trade in and out of different sectors cheaply and easily. This means it's now practical for ETF investors to pursue alternative methods of portfolio construction when it comes to your equity holdings, such as diversifying across sectors rather than by geographic allocation.
You can also employ a sector rotation strategy. Here you seek to overweight the sectors most likely to benefit from the next stage of the economic cycle. Alternatively, you might not trade your positions but instead permanently overweight particular sectors that you think have the best long-term prospects. For instance if you think energy production will benefit as the growing global population increases its consumption, you might hold a large position in an energy sector ETF.
To get a flavour of how the returns from different sectors diverge over time, see the Market Overview tool.
What do sector ETFs invest in?
Sector ETFs are index-tracking funds. They track sector indices maintained by the index providers. These indices are based on one of two different internationally recognised sector classification schemes:- The Industry Classification Benchmark (ICB)
- The Global Industry Classification Scheme (GICS)
An overview of the range of sector ETFs
| Region | Base index | Number of investable sectors on base index | ETF provider | Costs |
|---|---|---|---|---|
| Developed markets | MSCI World | 10 | db X-trackers, Lyxor, Amundi | 0.35% - 0.45% |
| Emerging markets | MSCI Emerging markets | 10 | db X-trackers | 0.65% |
| Europe | STOXX Europe 600 | 10 + 8 sub sectors | db X-trackers, iShares, Lyxor | 0.30%- 0.50% |
| Europe | STOXX Europe 600 Optimised | 10 + 8 sub sectors | Source | 0.30% |
| Europe | MSCI Europe | 10 + 2 sub sectors | SPDR, Amundi | 0.25% - 0.30% |
| USA | S&P Select Sector Capped 20% | 9 | Lyxor, Source | 0.20% - 0.30% |
| China | CSI 300 | 7 + 2 sub sectors | db X-trackers | 0.50% |
| Asia | MSCI AC Asia Ex Japan | 2 | Lyxor | 0.65% |
Source: justETF.com; As of 05/05/15
In addition, thematic ETFs have emerged in recent years, which are sector plays tracking more specialist indices.
For example, with the ETFS ROBO-STOX Global Robotics and Automation ETF you can get exposure to the high-tech manufacturing devices of the future, as represented by firms in the ROBO-STOX Global Robotics and Automation Index. These are more niche investments, and investing in them is closer to a stock picking approach than a broader sector allocation or rotation strategy.
Some potential downsides of sector ETFs
It's always important to consider costs when investing, and sector ETF fees are typically higher than those of regional or country-based ETFs. This makes it more expensive to hold a portfolio constructed using a sector-based approach. Be especially vigilant with more exotic or niche sector ETFs that may have a relatively small amount of Assets under Management, and hence higher costs.Also note that with a sector rotation strategy, you're not buying the whole market, but rather taking an active approach and holding a sub-set of companies in order to try to outperform. If you decide to follow a sector rotation strategy, you'll therefore have to get your sector calls more right than wrong if you're going to beat the (cheaper) market cap weighted indices. Make the wrong decisions and you'll underperform instead.
How to find the right sector ETF
You can begin your research with the Screener tool. Use the drop down filter under the Equity bar to select the sector you want to see ETFs for. You can refine your search further by selecting Region or Country.Selection of a sector based ETF
Source: justETF.com/find-etf.html
Hint for searching ETFs
Filter for "All Sectors" in order to get all ETFs which focus on sectors. If you want to exclude all sector ETFs from your search, choose the "No Sectors" filter.
