From the November 2009 issue of Research Magazine • Subscribe!

November 1, 2009

A Look at Top Sectors

There are more than 200 sector ETFs, making it one of the largest ETF categories.

There are many favorite sayings for avid sector investors. "Individual stocks come and go, but industry sectors never die," is one such expression.

The basic idea of sector investing is to focus on major economic investment themes and the specific sectors that stand to benefit the most. A sector strategy reduces the need for researching individual securities and also eliminates the risk of single stocks by taking a more diversified approach.

There are more than 200 sector ETFs, making it one of the largest ETF categories. Let's analyze some of this year's top-performing industry sectors.

Material Gains

Even though it's the tiniest S&P 500 industry sector, materials (XLB) are so far the top-performing S&P sector. XLB has climbed around 36 percent (performance figures are YTD through September 30 market close). This bested the broader S&P 500 (SPY) by 19 percent.

Materials stocks are closely connected to commodities. They cover industries like chemical makers, construction materials, containers and packaging, metals and mining, along with paper and forest products.

Other ETFs that invest in commodity stocks but with a global approach include the Market Vectors-RVE Hard Assets Producers ETF (HAP). The fund follows the Rogers Van Eck Hard Assets Producers Index, which consists of companies engaged in the agriculture, energy, metals and mining, forest products, and water.

The Hard Assets Producers Index is a modified capitalization weighted, float-adjusted index. The index is rebalanced quarterly and reconstituted annually. HAP charges 0.65 percent.

Technology Reemerges

Technology stocks (XLK) have risen 35.4 percent year-to-date and are the second best performing industry sector within the S&P 500. The technology industry accounts for 21 percent of the S&P 500's overall sector weighting, making it the largest sector within the index.

With almost $4 billion in assets, XLK is the largest technology ETF. There are almost 80 technology stocks inside XLK covering key segments like networking firms, semiconductor producers and software makers.

In 2008, XLK declined by 41.39 percent, compared to a 38.49 percent fall in the S&P 500. The fund's three largest holdings are currently Microsoft (9.69 percent), IBM (7.89 percent) and Apple (7.87 percent). XLK's annual expense ratio is 0.21 percent.

If you want more diverse exposure to technology stocks for your clients, the Vanguard Information Technology ETF (VGT) follows roughly 400 tech stocks within the MSCI US Investable Market Information Technology Index. The fund has $599 million in assets and this particular technology ETF is the most diversified among similar offerings. The median market size of technology stocks in the fund is $71.6 billion and VGT's annual expense ratio is 0.25 percent.

Financials Rebound

After a horrific 2008, financial stocks are on the mend. The Financial Select Sector SPDR (XLF) which follows S&P financial stocks has risen 19.3 percent so far this year. XLF includes financial stocks from key sub-sectors like banking, insurance and investment brokerage. The yield for XLF is around 3.49 percent.

To the surprise of many, stocks within the problem-plagued banking sector (KBE) have gained around 7 percent on the year and more than 25 percent over the past few months. The general interpretation by some analysts is that the worst of the recession and credit crisis is behind banks. Other analysts point to the deflated commercial real estate market as the next shoe to drop. Banks still face billions, maybe trillions, of dollars more in write-downs from the sagging commercial mortgage-backed securities market.

Hedging Sector Bets

What if you aren't too keen about investing in risky individual sectors? Instead of putting your money into narrow sector ETFs, the equal weight approach might be just the ticket. For example, the ALPS Equal Sector Weight ETF (EQL) owns each of the nine Select Sector SPDR ETFs in equal portions of 11.1 percent.

This type of strategy prevents any one sector from dominating the others. The nine Select Sector SPDR ETFs are rebalanced back to equal weight on a quarterly basis. EQL's annual expense ratio is 0.55 percent.

Another way to hedge your sector bets is to use short or inverse performing sector ETFs. For example, a client with too much net worth tied up in technology stocks could use the Direxion Daily Technology Bear 3x Shares ETF (TYP) to protect against the downside. TYP attempts to deliver opposite daily performance of tech stocks with 300 percent magnification.

Rather than buying and forgetting them, advisors should always closely monitor leveraged and short ETF positions.
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