Sector Investing with ETFs

Executive Summary

New: Playback the Webinar “Sector Investing with ETFs” with special guest, Vinny Catalano, author of Sectors and Styles


  • Over time, investors are better at picking industries than at picking stocks.
  • ETFs are a great way to get low cost, diversified industry exposure in the U.S. and Internationally.
  • There are close to 200 ETFs that focus on a sector, sub-sector or industry.  Examples include:

Domestic: XLFXLEXLKVDEIYE

Domestic – proprietary weighting:PRFEPTH

Global: IXC

International (non-US): DBNIRY

Industry rotation: PYH

Leveraged and Short: SKF

Investment case

Selecting the right industry is about as important as selecting the right stock.

That’s the finding of Jeffrey Busse and Qing Tong, authors of the recent academic paper “Mutual Fund Industry Selection and Persistence”.

Busse and Tong studied mutual fund performance and found that about half of the performance that a manager achieves by investing in, for example Deere & Co., can be explained by the initial decision to invest in the farm equipment industry.

Sector Investing Performs Better Over Time

That finding is probably not a big surprise to most investors. However, the authors go on to report that time eventually erodes the managers’ ability to continue pick the right stocks but time does not affect managers’ ability to pick the right sectors.

This is true even for managers of wildly successful funds who eventually attract so much capital that they are unable to maintain their stock selectivity.

Busse and Tong point to prior research that found consistent industry selection can explained by a manager’s ability to time industry allocations across the business cycle and maintain larger exposure to the energy, utilities and metals industries.

This finding is important to ETF investors because it validates a fundamental hypothesis of exchange traded funds investing – it is better to make low cost, diversified bets on sectors and industries than it is to make expensive and risky bets on individual securities.

The Busse and Tong paper is available at the SSRN eLibrary.

Overview

There are close to 200 sector, sub-sector and industry focused ETFs in the ETF MarketPro Directory.

The landscape is covered at a high level here and more detail will be available in the upcoming special report – Sector Investing with ETFs.

Sector Classification

The ETF Directory is organized into 10 sectors based on the Global Industry Classification Standard (GICS).  The 10 sectors are Energy, Materials, Industrials, Consumer Discretionary,Consumer Staples, Health Care, Financials, Information Technology, Telecommunications Services and Utilities.

Domestic

State Street is the market leader in Sector ETFs and sponsors the three largest including the Financial Select Sector SPDR Fund (XLF),Energy Select Sector SPDR Fund(XLE), and Information Technology Select Sector Index(XLK).

Vanguard covers each of the 10 sectors with ETFs.  The firms’ largest entry is the $700 millionVanguard Energy ETF (VDE).

iShares also offers 10 domestic sector ETFs – the largest is also in energy – the Dow Jones U.S. Energy Sector Index Fund (IYE).

Domestic – Proprietary Weighting

PowerShares offers two sets of fundamentally weighted sector ETFs.  The ETFs based on the FTSE™ Research Affiliates Fundamentals Index use four fundamental measures of firm size: book value, cash flow, sales and dividends.  The $25 millionPowerShares FTSE RAFI Energy Sector Portfolio (PRFE) is the largest.

PowerShares also offers sector ETFs that use the proprietary Intellidex index which evaluates and selects companies with the greatest capital appreciation potential based on a variety of investment merit criteria, including fundamental growth, stock valuation, investments and risk factors.

The largest is the $114 millionPowerShares Dynamic Healthcare Sector Portfolio (PTH).

Global

iShares offers Global Sector funds including the $1.1 billion S&P Global Energy Sector Index Fund (IXC).

International

WisdomTree covers the 10 sectors outside of the U.S. and Canada with fundamentally weighted ETFs.  The $100 million WisdomTree International Basic Materials Sector Fund (DBN) is the largest.

State Street recently introduced a series of non-US sector ETFs including the SPDR S&P International Health Care Sector ETF (IRY).

Industry Rotation

Some ETFs actively rotate between industries based on fundamentals or other proprietary strategies.  One example is the Value Line Industry Rotation Portfolio (PYH) which rotates holdings quarterly based on Value Line’s Timeliness ranking.

Leveraged and Short

ProShares offers a series of leveraged and short sector ETFs.  One example is the $2.5 billionUltraShort Financials (SKF).

An interactive listing of Sector ETFs is available in the ETF MarketPro Directory

Top Performers

Largest

1. Financial Select Sector SPDR Fund (XLF) – $6,410 million
2. Energy Select Sector SPDR Fund (XLE) – $5,363 miillion

Lowest Cost

1. Vanguard Energy ETF (VDE) – 0.22%
2. Vanguard Information Techology ETF (VGT) – 0.22%

See the directory.