A Complete Guide to ETF Sectors
If you’re a trader looking to expand your portfolio, Sector Exchange-Traded Funds (ETFs) may seem like a new mystery to unfold. Here's your explainer on sector ETFs and why you might consider adding them to your portfolio.
Important: If you need a refresher on ETFs, be sure to check out this helpful guide to ETFs.
What is a Sector ETF?
Much like a typical ETF, a sector ETF is a pooled investment that tracks specific equities and stocks instead of investing in one particular company’s stock.
What makes sector or industry ETFs unique is that they focus on subsets of the economy. For example, sector ETFs may include a variety of energy securities or technology stocks.
Some sector ETFs are even narrower, limiting the stocks they track to subgroups of an industry or certain companies that meet specific size requirements. While most sector ETFs focus on US-based equities, some invest worldwide to capture global sector performance.
Good to know: Subsectors of sector ETFs are often defined by the Global Industry Classification Standard (GICS).
What are the Most Common Types of Sector ETFs?
There are several sector ETFs that different traders prefer based on their own unique strategies. Below you’ll find a list of some of the most popular sectors.
Healthcare ETFs
Track companies that produce or deliver medicine and other healthcare-related services or goods.
Information technology ETFs
Track companies that research and develop goods and services for computer systems, software, programming languages, and data and information processing and storage.
Energy ETFs
Track companies that produce, research, or manage energy resources.
Real Estate ETFs
Track companies involved in real estate and related investments.
Consumer Staples ETFs
Track companies that deal in regular household items, including food, beverages, and tobacco.
Consumer Discretionary ETFs
Track companies that are involved with non-essential goods and services that are purchased with discretionary funds, including clothing, entertainment and leisure, and motor vehicles.
Utilities ETFs
Track companies that produce and deliver electricity, natural gas, water, and other utility services.
Strategies for Trading Sector ETFs
Each sector has its own unique risks and potential rewards. For example, the technology sector has historically been one of the most volatile, while the utility sector tends to remain more stable.
Because individual sectors exhibit more volatility than the overall stock market, it’s important to develop a game plan before you dive in.
Let’s explore some examples of strategies and tips for trading sector ETFs, so you can begin to consider whether sector ETFs might suit your investing style.
Popular Sectors
Some traders try to use sector ETFs to capitalize on the next big thing. When a new sector becomes a hot-ticket item, they try to get in early seeking to profit when the index rises as popularity increases.
One of the biggest risks with going for “hot” sectors and trending industries is that popularity is fickle. Top sectors often see sudden and significant price drops that come faster than their initial increase.
Historical sector trends: In the 1990s, there was a huge boom in the tech industry, while the early 2000s saw a dramatic rise in gold mining.
Rotating Sectors
Instead of trying to time the "next big thing," some traders rotate sectors based on previous trends in the sector market. Specific market sectors may do better than the overall market at different stages of the business cycle, so an investor will weight (and even overweight) their portfolio based on those stages.
For example, during the early stages of economic recovery, financial and transportation stocks have previously outperformed the overall market. As economic recovery continued to unfold, businesses moved out of survival mode and spent more, making technology, operations, and capital goods rise. And finally, in late economic recovery stages, sectors based on discretionary funds tended to flourish.
If traders want to use this strategy, they usually need to know the business cycle inside and out to time their entries and exits.
Diversifying Your Portfolio
Some traders will use sector ETFs to diversify their portfolio based on how the overall stock market is behaving, weighting their portfolio in sectors that are performing well.
This approach is an alternative to using style ETFs, which track a specific investment style/asset class like small-cap, medium-cap, and large-cap stocks. Instead, sector ETFs can help to allow traders to build their portfolio to match their risk tolerance — aggressive traders can overweight in more volatile sectors like technology, while conservative traders can focus more on more stable choices like utilities.
Avoiding ETF Overlap
Buying sector ETFs can help traders diversify their portfolio, but they should be careful of overlap. If they already own specific stocks within that sector or have invested in style ETFs or a broad-market index, sector ETFs are simply doubling up their exposure for an extra cost.
Important to remember: When sector ETFs are used strategically and without overlap, they may help a trader raise or lower their overall risk/reward profile. For example, a trader may invest in a utility sector ETF to conservatively add diversity while managing risk. A more aggressive trader might try to diversify by investing in more volatile sectors
What Other Factors Should Be Considered When Selecting Sector ETFs?
When considering adding sector ETFs to your portfolio, you should look at:
Size: Whether or not the ETF restricts holdings based on the size of a company’s market capitalization.
Number of holdings: How many companies are within that ETF’s sector and if the ETF focuses on the broad sector or only a smaller subset.
Location: If the sector ETF provides exposure to global stocks in the same sector because some sector ETFs are more regional and focus solely on US stocks.
Pros and cons of Sector ETFs
Pros
Help traders add new market opportunities to their portfolio without having to spend time researching and buying individual stocks.
Provide broader exposure and diversification, often at a lower cost than investing in individual stocks.
Cons
Can make traders spend more on trading by accidentally investing in sectors they already have invested in.
Are significantly impacted by outside influences like culture, government, economy and other factor shifts.
Sector ETFs carry the risk of underperformance if the particular sector or sectors chosen experience a downturn. This underscores the importance of thorough research and understanding the specific risks associated with the sectors in question.
While ETFs offer diversification benefits compared to stock ownership, they are not immune to market fluctuations. Investors should be mindful of the inherent risks associated with ETF investing, including market volatility and potential loss of principal.
FAQs for Sector ETFs
- Why should you consider adding Sector ETFs to your portfolio?
Sector ETFs can help traders add diversity to their portfolio and invest in a broader area of the market at a lower cost and without extra research or trades for individual stocks.
- What are the 11 Sectors of the S&P 500?
The 11 Global Industry Classification Standards (GICS) sectors commonly used for sector breakdown reporting include:
Energy
Materials
Industrials
Consumer Discretionary
Consumer Staples
Healthcare
Financials
Information Technology
Communication Services
Utilities
Real Estate
- Are sector ETFs a good investment?
Deciding which financial instruments to invest in depends on your unique investing strategy. Sector ETFs can offer investment objectives, increased portfolio diversification, and broader investing opportunities at a lower cost. On the other hand, if your portfolio already includes a number of stocks tracked by the sector ETF it may duplicate your efforts and increase your investing costs.
Important Information: Before investing in an ETF, you should read both its summary prospectus and its full prospectus, which provide detailed information on the ETF’s investment objective, principal investment strategies, risks, costs, and historical performance (if any). You can find prospectuses on the websites of the financial firms that sponsor a particular ETF, as well as through your broker.
A Word About Risk: Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. ETFs are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, international securities, commodities, fixed income, and more. An ETF may trade at a premium or discount to its net asset value (NAV).