If you’ve started investing recently, you’d probably noticed that your portfolio is heavily weighted towards tech stocks. While this would have been rewarding in 2020, the past 2 years would have been a wake up call to take a look at your portfolio diversification.
If you’re looking for a simple way to diversify your portfolio without having to research and pick individual stocks, sector ETFs are a good way to start.
Here’s everything you need to know:
What is a Sector ETF?
A sector exchange traded fund (ETF) invests in a portfolio of companies operating in a specific sector or industry, such as technology, healthcare, or energy. Sector ETFs offer investors exposure to a particular sector without the need to pick individual stocks.
Advantages of investing in Sector ETFs
Sector ETFs offer the following advantages for investors who are looking for exposure in specific market sectors or industries:
- Targeted Exposure
Sector ETFs allow you to target specific sectors or industries that you believe will outperform the broader market.
- Diversification
Sector ETFs provide you with a diversified portfolio of companies within a specific sector, which can help reduce risk of picking 1 bad stock.
- Liquidity
Sector ETFs are traded on major stock exchanges, making them easy to buy and sell, and typically have high trading volumes, which means you can enter and exit positions quickly.
How to make use of Sector ETFs?
There are several ways that investors can make use of Sector ETFs:
1) Diversification of portfolio
The most basic usage of Sector ETFs is to provide diversification in a portfolio.
If you are already investing in stocks but realized that your holdings are overly concentrated in popular sectors like technology, then Sector ETFs could be an easy way to diversify.
You could consider sector ETFs that give you exposure to particular industries that you do not wish to pick individual stocks in. Some examples include Energy, Industrials and Real Estate.
2) Gain exposure into trending sectors
Another common use for Sector ETFs is to gain exposure into trending sectors, in the short term.
For example, energy stocks had a good run in 2022 due to a mixture of low supply, rising demand and rising oil prices. If you were to screen for energy stocks on Yahoo Finance, you’ll have to screen through over 214 stocks. This is very time consuming and intimidating if you are not familiar with the energy sector.
Instead, you could invest in XLE, an Energy Sector ETF to ride on the energy stock run.
In 2022, here’s how the XLE fared against individual stocks:
| Stocks / ETF | 2022 returns |
| XLE | 57.6% |
| Exxon Mobil (XOM) | 80.26% |
| ConocoPhillips (COP) | 63.48% |
| Chevron (CVX) | 52.95% |
| Shell (SHEL) | 43.42% |
| BP | 43.7% |
XLE gives you a pretty good return without having to pick the winning stock out of 214 possibilities. In hindsight, we know that XOM and COP would allow us to get even better returns in 2022. However, if you are not familiar with the energy sector, XLE would have been a safer buy.
3) Hedge against risk
On the flipside, you can also use sector ETFs as a hedge against market risk.
For example, if you’re worried about a potential economic downturn, you may consider investing in defensive sectors such as utilities, healthcare, or consumer staples, which tend to perform well during periods of market turbulence.
4) Research ideas for individual stocks within a particular sector
By using Sector ETFs as a starting point for your research, you can seriously shorten your research process.
Sector ETFs usually contain a portfolio of companies within a specific sector.
By taking a look at the holdings within a sector ETF, you are essentially narrowing down your universe of stocks to research in. And if you download the holdings of sector ETFs, you usually get to shortcut your process as some of them would include key financial metrics as well.
5) Yardstick for Performance
If you’re a DIY stock investor, your aim is to beat the market returns. To know how well your portfolio is doing, you’ll need a benchmark.
While indices like the S&P 500 and Dow Jones Industrial Average are good benchmarks, if your portfolio is heavily weighted in specific sectors, you may want to use Sector ETFs as a more accurate yardstick.
For example if you’re investing primarily in tech stocks, you may want to compare your performance against SMH, or if you’re heavily weighted in SaaS stocks, you may want to compare your performance against SKYY.
This gives you a clearer idea of how your portfolio is really doing, especially in times when a sector is doing either particularly well or particularly poorly.
Risks of investing in Sector ETFs
There are no perfect investment vehicles. These are the potential drawbacks to investing in sector ETFs:
- Sector Risk
Sector ETFs are concentrated in a specific industry or sector, which means the ETF will experience losses when the sector experiences headwinds or poor performance.
- Exposure to Cyclical Nature
Some sectors are more cyclical in nature and may be more susceptible to economic downturns, which can lead to more volatile returns.
Remember, with Sector ETFs you are only getting exposure to specific sectors of interest. While investing in sector ETFs, you should also make sure that your overall portfolio remains well diversified.
Examples of Sector ETFs
Here are 11 broad Sector ETFs based on the GICS sectors:
- Energy: Energy Select Sector SPDR Fund (XLE)
- Materials: Materials Select Sector SPDR Fund (XLB)
- Industrials: Industrial Select Sector SPDR Fund (XLI)
- Consumer Discretionary: Consumer Discretionary Select Sector SPDR Fund (XLY)
- Consumer Staples: Consumer Staples Select Sector SPDR Fund (XLP)
- Health Care: Health Care Select Sector SPDR Fund (XLV)
- Financials: Financial Select Sector SPDR Fund (XLF)
- Information Technology: Technology Select Sector SPDR Fund (XLK)
- Communication Services: Communication Services Select Sector SPDR Fund (XLC)
- Utilities: Utilities Select Sector SPDR Fund (XLU)
- Real Estate: Real Estate Select Sector SPDR Fund (XLRE)
What is the Global Industry Classification Standard (GICS)?
The Global Industry Classification Standard (GICS) was developed by Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P) to systematically classify companies. This classification system has 4 levels; sector, industry group, industry and sub-industry.
The purpose of the GICS is to provide a common classification system that would allow analysts and investors to easily identify and compare a company against its competitors. This would allow us to quantify how well a company is performing, especially within its field or against its competitors.
While the GICS sectors are a good place to start exploring, ETF issuers like iShares and Vanguard have developed their own sector classifications too. If you’re out of ideas, you can explore what the individual ETF issuers are to offer too.
Frequently Asked Questions
You may have wondered about the following questions during your research:
Sector ETFs vs Thematic ETFs
Sector ETFs give you exposure to specific sectors or industry (eg. Technology, Energy, Healthcare) while Thematic ETFs allow you to invest in specific themes or trends (eg. Cybersecurity, Renewable Energy, Gene Editing, ESG and even AI).
Thematic ETFs are often more narrowly focused than sector ETFs, and may seek to capture opportunities that are not available in broader market sectors.
Sector ETFs vs Index ETFs
Sector ETFs give you exposure to specific sectors or industry (eg. Technology, Energy, Healthcare) while Index ETFs allow you to invest in indices like the S&P 500 or the Dow Jones Industrial Average.
Index ETFs are broader than Sector ETFs and usually include companies across multiple sectors.
For more, read about the 5 differences between ETFs and Index Funds
How many Sector ETFs should I own?
This depends on your overall investing strategy. If your aim is to diversify your portfolio across sectors, you may want to refer to the 11 sectors classified under the Global Industry Classification Standard (GICS).
However, if you plan to use Sector ETFs to ride on the short term growth of specific sectors, you may only need to own 1 selected ETF that would give you the necessary exposure.
If you are not sure where to start, we shared 2 basic ETF portfolio strategies in our ETF investing guide.
Is it good to invest in Sector ETFs?
Sector ETFs give you exposure to a portfolio of companies within a selected sector or industry. If you’re looking to own a piece of a particular sector in your portfolio without having to pick individual stocks, sector ETFs are a good option for you.
However, do remember that within sectors there’ll be companies that outperform the rest. With a sector ETF, you’ll only pocket market returns which is the average performance of the best and worst companies held by the sector ETF.
If you intend to chase higher returns, you may want to learn to pick your own stocks.
