Sector and industry ETFs

Industry sector ETFs are a dynamic and growing market. Virtually every major industry group has multiple indexes that track industry performance. The obvious benefit of sector ETFs is they provide a means of investing in an entire industry; however, they can be used for other purposes as well.

Industry sector ETFs invest in the stocks and securities of specific industry sectors, such as energy, biotechnology, or chemicals. Most invest in US stocks, but increasingly, ETF providers are offering products that mimic global industry sector performance. Finally, leveraged and short industry sector ETFs are available.

Major providers of industry sector ETFs include iShares, PowerShares, State Street, Vanguard, and Merrill Lynch. Generally speaking, the cost of investing in large industry sectors (such as health care or energy) is less than the cost associated with more concentrated industries (such as oil service or nanotechnology).

Sector risk and reward

Historically, different industry sectors have exhibited different risk/reward characteristics. Roughly speaking, the technology sector tends to exhibit the most volatility over time, while the utility sector tends to be the least volatile. And, in general, individual sectors will exhibit greater volatility than the overall stock market.

The hot sector strategy

Many investors look to sector ETFs as a means to profit from the next hot industry. They remember, perhaps, the tech boom of the 1990s or the big jump in gold mining stocks in the early 2000s. The difficulty of this kind of investing, of course, is that the hot industries often drop in price as fast (or faster) than they rise. Timing and risk management strategy are critical for investors utilizing this approach.

Sector rotation strategy

Rather than search for the next hot sector, a related strategy is to overweight your portfolio in accordance with different phases of the business cycle. Research indicates that various stock market sectors tend to do better than the overall market at different stages of the business cycle. Using this strategy, an investor might remain fully invested in the stock market, but will weight their portfolio in accordance with each phase of the cycle.

Typically, in the early stages of an economic recovery, transportation and financial stocks usually outperform the overall market. As the recovery takes hold and companies begin to invest more in operations, technology and capital goods stocks usually benefit. In the later stages of the recovery, consumer goods, energy, and precious metal stocks tend to outperform the market. As the economic recovery begins to lose steam, so-called non-cyclical stocks, such as health care and food stocks generally will outperform the overall market.

Of course, each economic environment is different and the markets always anticipate the next phase. Investors embarking on this strategy need to do a good deal of homework on the business cycle and be prepared to move slightly in advance of actual changes in the business cycle.

Diversified sector portfolio

The most widely accepted method of stock market diversification is to build a portfolio that consists of a mix of small-, medium-, and large-cap stocks and a mix of growth and value strategies, utilizing style ETFs. An alternative approach is to build a portfolio with sector ETFs that mimics the overall stock market. The advantage here is that you can fine-tune the portfolio to match your risk tolerance. For example, an aggressive investor could overweight the technology sector; a more conservative investor could overweight the utility sector.

The downside to creating a diversified portfolio in this manner is that industry sector ETFs tend to cost a bit more than style ETFs. Also, there is considerable research which indicates that a portfolio weighted slightly to small-cap stocks and value strategy tends to outperform the entire market. A sector-based portfolio will tend to be weighed toward large-cap stocks and will split value/growth strategies evenly. Of course, as with any tendency based on market history, past performance is not necessarily indicative of future results.

Avoid ETF duplication

If you already are exposed to the overall stock market through a blend of style ETFs or a broad market index, it makes little sense to buy a large number of industry sector ETFs in a further quest for diversification. All you are simply doing is increasing your overall cost of investing.

However, strategically utilizing an industry sector ETF may make sense if you want to slightly raise or lower your overall risk/reward profile in the context of your broader, diversified portfolio. For example, to lower your risk, you might want to invest in a utility sector ETF. To take on more risk (and the potential for higher reward), you might want to invest in an energy or precious metals sector ETF.

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Article copyright 2011 by Richard A. Ferri, Dan Dion, Carolyn Dion, and David J. Abner. Reprinted and adapted from The ETF Book, The Ultimate Guide To Trading ETFs, and The ETF Handbook with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.