Savvy Sector Strategies

Today there are more than 350 different sector ETFs on the market, says Morningstar's Jason Kephart. How are investors using these vehicles, and what are the pitfalls?

Kephart moderated a panel at the Morningstar ETF Conference that tackled these questions. Panelists included Michael Arone from State Street Global Advisors, Denise Chisholm from Fidelity, and Corey Hoffstein from Newfound Research.

Sector Investing: Why Bother? Chisholm made a case for sector investing, noting that it allows investors to diversify beyond the standard value/growth styles. By employing a sector approach to at least a portion of their portfolios, investors can benefit from the additional diversity and low correlations that sectors bring to the table.

In a survey of financial advisors, Arone and his colleagues found that this group of investors uses sector strategies to manage risk, to diversify, to make tactical bets, and to generate additional alpha (or return above the market). Given the less-than-rosy forecasts for equity-market returns going forward, said Arone, many investors are turning to strategies that may give them more than just the market's return

And unlike buying individual stocks, a sector fund can provide an investor with some internal diversification yet not be overly diffuse, added Hoffstein.

Pitfalls to Avoid The panelists argued sector-focused investors to know what they own, and warned them not to get too granular--say, not much beyond the industry level--unless they're fully prepared to handle the associated risks.

"If thinking about healthcare sector ETF, you're pretty well diversified," said Chisholm. "The further down the spectrum you go, the more alpha you can produce, but the more downside risk you’ll have." Chisholm suggested reducing the size of your investment the more focused your investment is, to account for the increased risk.

Arone noted that that the more specific the investment becomes, the more it behaves like an individual stock, with its associated volatility.

"The more granularity there is, the more opportunity there is--and the more stomach you need to deal with the short-term volatility," he added.

Another trap sector-based investors fall prey to is eroding their returns with costs. Hoffstein notes that costs don't begin and end with a fund's expense ratio. Investors also need to consider any costs associated with their own trading.

Lastly, sector investors need to makes sure they understand the portfolio and strategy behind the ETF.

"What is the index methodology underlying the ETF? Is it passive market-cap weighted, is it more active rules-based, or a true active ETF?” says Hoffstein.

Sectors to Watch Today Kephart noted that utilities and real estate are among the most popular sectors today, based on flows. That's not surprising, given their lush yields. Chisholm noted that utilities and consumer staples could have room to run, based on history. We're in the midst of a profit recession, says Chisholm. And these two sectors generally outperform when profits are contracting. In her estimate, we're only about a third of the way there, in terms of the typical profit recession's duration.

Meanwhile, the quantitative selection model that Arone's team uses are favoring consumer staples and tech. He acknowledges that there is a great sector battle going on in the market. Utilities, real estate, and consumer staples have benefited from the mistrust of the ensuing rally and the idea of lower rates for longer, he said. Recently, though, investors have shown some interest in financials and tech.