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Sector ETFs: Use at Your Own Risk

Consider cost, risk, and portfolio overlap before playing with sector ETFs.

Dan Culloton, 06/13/2006

Exchange-traded funds seem to encourage myopia. As the variety of ETFs widens, the individual funds themselves are narrowing.

Most of the new ETFs launched in recent months have been sector or industry funds that hone in on ever-thinner slices of the stock market, such as home builders, oil equipment makers, biotechs, aerospace and defense companies, and even nanotech and water industry stocks. Currently, more than 40% of all ETFs are sector or industry funds, and there are many more on the way. (PowerShares alone last week filed regulatory documents proposing 20 new sector funds.) It's possible that soon specialty funds will account for more than half of all ETFs. The percentage of conventional mutual funds that focus on a single sector or industry, by contrast, is about 6%.

This is an exciting development if you believe that there is a new game afoot in investing: that individual security or manager selection doesn't matter as much as asset allocation, and that ETFs allow you to slice and dice your way to superior returns without all that pesky research or stock-specific risk. I think, however, that sector ETFs are a bit trickier to use effectively than advocates of the slice-and-dice approach to investing would have you believe.

The history of sector offerings in the conventional mutual fund universe shows investors, professional and novice alike, tend to misuse them. They chase hot returns and then dump the funds when they cool off or prove to be more volatile than expected. Sure, sector ETFs offer a lot of flexibility and variety, but investors who think they can ignore fundamentals and risk profiles do so at their own risk. Here are some factors you should consider before adding sector ETFs to a portfolio.

The Narrower the Fund, the Higher the Price
Adding sector ETFs to your mix of holdings is likely to increase your total costs and reduce your return, which counteracts one of the key advantages of ETFs--their low costs.

Sector ETFs are more expensive than more-diversified ETFs. The average non-sector ETF has an expense ratio of 0.36%, while the average sector ETF cost 0.45%. Even if you assembled a collection of relatively inexpensive sector ETFs--say an equal-weighted portfolio of 10 Vanguard domestic sector Vipers--and never traded, you would still surrender more to costs than if you bought more-diversified ETFs. The average expense ratio of 0.26% for the equal-weighted sector portfolio would be more than three times that of Vanguard Total Stock Market VIPERs VTI, and more than twice that of an equal-weighted portfolio of  Vanguard Large Cap VIPERs VV, Vanguard Mid Cap VIPERs VO, and Vanguard Small Cap VIPERs VB.

Throw in some more expensive sector ETFs, such as PowerShares WilderHill Clean Energy PBW and its 0.7% expense ratio, as well as trading costs incurred during periodic rebalancings or sector rotations, and the hurdle between you and outperformance gets even higher. You have to add a lot of value on a consistent basis to make this approach pay.

There's Still Plenty of Stock Risk
Think your sector or industry ETF is immune from kind of blowups that often hit individual stocks? Think again. Many sector ETFs are dangerously concentrated in a handful of names, largely because they're composed of slices of market-cap-weighted equity indexes.

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