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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.

For example, Energy Select SPDR XLE keeps more than a fourth of its assets in two holdings, ExxonMobil XOM and Chevron CVX. Meanwhile, Materials Select SPDR XLB has more than a fourth of its money in DuPont De Nemours E.I. DD and Dow Chemical DOW. Consequently, these top-heavy ETFs can be more volatile than the typical stock in their sectors. In the month ending June 9, for instance, the Energy SPDR fell 10.4%, while the average energy stock dropped 9.4%. During the same period, the Materials SPDR shed 12.5% as the typical industrial materials stock slipped 10.4%.

Some ETFs try to mitigate such variability by tracking indexes that keep all their holdings equal or modify the weightings of their constituents to keep a few stocks from dominating. That still doesn't immunize the funds against volatility, though, especially if the ETFs track tightly focused indexes. PowerShares Dynamic Energy Exploration PXE and PowerShares Dynamic Oil & Gas Services PXJ control the size of their holdings, but are extremely limited in scope with just 30 stocks each. As the energy sector fell in the month ending June 9, these ETFs plunged 12.6% and 15.7%, respectively. That's no better than the average actively managed conventional natural resources fund faired over the same period (it lost 12.5%). One losing month does not a loser make, but it does demonstrate that such parochial funds have nowhere to hide when the sky falls on their corner of the market.

Know What You Own
Just because an ETF purports to track consumer or technology stocks, that doesn't mean they track the ones you want. You'd think that at this point in market history we might have arrived at clear universal standards for what companies belong in what sectors. Alas, that is not the case. The stocks included in sector ETF depend on how the index it tracks is constructed.

If you buy Technology Select Sector SPDR XLK, for example, you also get a big helping of telecom services stocks, such as Verizon Communications VZ and AT&T T, while rivals like iShares Dow Jones US Technology IYW and Vanguard Information Technology VIPERS VGT play it pretty straight with hardware and software stocks.

Consider also Wal-Mart Stores WMT. Even though it is the world's largest retailer, Wal-Mart shows up in the Consumer Staples Select Sector SPDR XLP and the Vanguard Consumer Staples VIPER VDC, alongside the makers of tangible goods like Procter & Gamble PG. Meanwhile it's the biggest holding in iShares Dow Jones U.S. Consumer Services  IYC, which owns lots of merchants including Target TGT, Lowe's Companies LOW, and Home Depot HD. By the way, if you are really keen on having exposure to those two home improvement retailers, don't buy PowerShares Dynamic Retail PMR. They're not there; they're in PowerShares Dynamic Building & Construction PKB.

Confused? I don't blame you. It's clear that if you don't pay attention you can easily foul up your asset-allocation plan when you start mixing sector and industry ETFs, owning too much of one stock and not enough of another, and paying too much for it all. Even when it seems like a fund's holdings should be obvious, it's still important to know what you own.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Dan Culloton is a senior analyst with Morningstar. He doesn't own shares of any securities mentioned in this article.

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