Schwab’s Top Picks and Tips for Sector ETFs

Tactical investors may want to stay neutral, and real estate ETFs are a popular choice

Schwab rates the IT sector to Outperform. Schwab rates the IT sector to Outperform.

Three exchange-traded fund (ETF) experts took a closer look at sector-specific ETFs during Charles Schwab’s “Every Third Friday” media call on Friday.

The takeaways? Tactical investors may want to take a neutral stance due to market uncertainty. Schwab is overweight in the information technology sector. Real estate ETFs are the most popular sector ETF so far this year, while Schwab Advisor Services has captured about 45% of all sector ETF inflows year to date. And finally, when in doubt, research, research, research.

Here are the highlights:

1) Brad Sorensen, managing director and sector analysis, Schwab Center for Financial Research

Looking at tactical investing ideas, Sorensen said that now is certainly an interesting time in the markets. “We’ve reverted back to what we saw in 2010 and 2011, with risk-on, risk-off trading rather than specific sector fundamentals being the focus,” Sorenson said. “Investors have taken money out of the more aggressive sectors and put it into more defensive sectors and vice versa as optimism has grown. We’ve seen some of those more cyclical sectors perform better, so it’s been frustrating for sector investors who do tactical allocations that there’s a lot of underlying sector fundamentals that have returned to being ignored while the focus is on the major macro events.”

What’s Sorensen’s advice for investors? Stay relatively neutral. “It’s an uncertain time,” he said. “We don’t want to make huge bets one way or another.”

Schwab has moved into a more defensive position just this week on sector calls. Mostly neutral on most sectors, Schwab has moved its view of the cyclical industrials sector down to Underperform from Market Perform, and has moved utilities to Market Perform from Underperform. Schwab's view remains Outperform on information technology.

“It’s a barbell approach that has a little bit of a defensive flavor,” Sorensen said. “As we’ve seen in past years when there’s been a downturn, information technology has held up relatively well. They’re increasing their dividend payments and their balance sheets are extremely solid with large cash balances, and businesses are willing to spend first on productivity-enhancing items rather than on labor.”

2) Eric Pollackov, managing director, ETF Capital Markets, Charles Schwab

Turning to asset growth among Schwab clients in sector ETFs this year, Pollackov said growth is flat as of the end of the May. Sector ETFs account for about 13% of the ETF assets at Charles Schwab, and they captured about 18% of the net flows year to date. Meanwhile, Schwab Advisor Services has captured about 45% of those sector ETF inflows year to date and account for 49% of the sector ETF assets.

What are the most popular sector ETFs so far this year? “Real estate exchange-traded funds captured the most flows year to date,” Pollackov said, "and I think a lot of that has to do with the yield and interest rate environment we’re currently in. That’s almost double any other sector on our platform. There’s moderate asset growth in the other sectors of only 9%, and financial ETFs had the strongest asset growth at around 23%, which had to do with the low valuations of the stocks at the end of last year.”

Consumer-defensive, communications and utilities are the only sectors that have seen negative flows year to date.

3) Michael Iachini, managing director, ETF Research, Charles Schwab Investment Advisory

With about 300 different exchanged-traded products in the sector-specific universe, the vast majority of which are ETFs, the number of products vary from sector to sector, Iachini noted. Communications has only eight to 10 ETFs, while energy has more than 50.

“Every sector has plenty of choices; there’s not a single sector ETF and everybody buys that one,” Iachini noted. “With any investment, and this applies equally to sector ETFs, we always tell investors, “Know what you’re buying. You don’t know what it is until you dig into the ETF. The reason it matters so much for sector ETFs is because there’s so much variety, even within a single sector.”

What’s Iachini’s advice to investors, considering all the available choices?

No 1: Costs vary. ETFs are generally thought of as low-cost investments, “but they’re not all equally low,” Iachini said. Expense ratios for U.S. large-cap stock ETFs cost about 25 basis points while emerging markets may cost 85 basis points in terms of annual expenses.

Further, consider an ETF’s tradeability: not every sector-specific ETF is easy to trade and liquid. And look at the bid-ask spread, Iachini said. “You can see some spreads that are as wide as 1% or even higher of the ETF’s price. Every time you buy you’re paying half that spread, and every time you sell you’re paying half that spread. If you’re using these ETFs tactically in a more short-term holding approach, those spreads are really going to add up.”

For more about sector-specific ETFs, read How to Buy Facebook Without All the Risk at AdvisorOne.

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