From the September 2010 issue of Research Magazine • Subscribe!

September 1, 2010

Seeking Sector Performance

With the stock market flat through much of 2010, more and more advisors are using sector investing strategies. Here's what they're banking on: If broader measures of market performance aren't going to deliver performance, than it'll have to be industry sectors concentrated in equity segments with the best opportunity.

One significant advantage of sector investing is the ability to customize client portfolios. Advisors can help their clients own the exact pieces of the market to which they want investment exposure. The right sectors can be overweighted whereas the wrong ones can be underweighted or avoided.

Furthermore, sector ETFs are an excellent substitute for individual stocks. Instead of increasing financial risk by owning a single stock like Microsoft or Chevron , owning a technology and energy ETF can help the client gain market exposure but with greater diversification.

To discuss the potential of sector investing, Research conducted a one-on-one interview with Dan Dolan of Sector SPDRs. The firm's nine ETFs follow the nine S&P 500 industry sectors and have a combined $30 billion in assets.

During tough economic times like these, what industry sectors tend to do well? How about as the economic recovery gains footing?

The real question is, where is the economy going? Sector performance should anticipate economic activity. The economy may be slow today but are we moving forward and recovering or are we moving deeper into recession? If you believe the economy will remain slow for an extended period of time focus on defensive sectors like health care (XLV), consumer staples (XLP) and utilities (XLU). These sectors have consistent earnings and tend to outperform in tough environments. If you feel the worst is behind us and the economy will improve, focus on early cycle sectors like technology (XLK), industrials (XLI), consumer discretionary and materials (XLB). As economic activity expands, earnings can improve rapidly for companies in these sectors.

Over the past few years we've seen a string of corporate failures and shocks of epic magnitude. From Enron to Lehman Brothers to BP -- investors have been stung badly. How can advisors help their clients to minimize risk?

Sector ETFs can help investors minimize single-stock exposure and avoid investment disasters. By investing in a basket of securities (ETFs) you can take advantage of an investment theme while at the same time significantly reducing portfolio risk. Single-company meltdowns like Enron, Lehman Brothers and BP can be avoided by spreading risk and reducing concentrated equity exposure.

Interest rates are still at rock bottom levels and it's forced a lot of advisors to rethink their clients' income strategy. Talk about strategies to help them.

The search for yield will continue for years. Equities/ETFs can provide an attractive fixed-income alternative for a portion of client portfolios. The utilities sector is a good place to start. The sector currently yields over 4.5 percent with dividend growth rates around 3 percent. Telecom is another focus sector for income. Some individual companies in this sector have current dividend yields well above 6 percent.

A joint panel of the Securities and Exchange Commission and Commodity Futures Trading Commission determined that 27 percent of all U.S.-listed ETFs were impacted with "broken trades" in the May 6 "flash crash." What went wrong? Does this diminish the viability of ETFs as investment vehicles?

The May 6th "flash crash" situation was a market problem for all securities including ETFs. If an investor believes this will be an ongoing problem they should focus on the most liquid securities in the market. Many individual stocks and ETFs trade millions of shares per day with penny-wide spreads. This liquidity helps all investors and should minimize exposure to wide markets and bad trades.

How has sector investing evolved or changed over the years?

Sector investing has changed significantly in the last 10 years. It has evolved from being perceived as high risk investing to a portfolio risk reduction tool for many investors today. Investors implement asset allocation strategies using sectors to customize their portfolios to meet certain investment objectives. In addition, many investors use sectors as stock substitutes. They can implement their investment strategy without incurring significant single stock exposure.

For sector mutual funds the turnover of portfolio holdings is often high, which translates into substantial tax liabilities for the investor. How have the Sector SPDRs performed in this regard?

Sector SPDRs have not paid a capital gain distribution in ten years. Our ETFs are index-based which minimizes turnover and the ETF structure is simply better for investors in taxable accounts.

The landscape of industry sector ETFs has become quite crowded and confusing today. What are key factors investment advisors should use in their selection process?

The sector ETF landscape is getting very crowded. Investors have multiple ETFs to [choose] from in almost every category. Once the appropriate slice of the market has been identified investors should then focus on expenses and liquidity. Low costs will enhance shareholder value over time and high trading volume will allow investors to move in and out of the security with very tight spreads (again lower costs).

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