From the June 2013 issue of Investment Advisor • Subscribe!

Three Reasons for Sector Investing via ETFs

The industry-focused strategy can help investors reduce market risk and improve cash flow

Sector investing has been given a bad rap.

To proponents of traditional asset allocation and broad diversification, investing in single industry sectors via ETFs is tantamount to speculation. Why bet on energy or financial stocks when a broad market index fund already holds these sectors?

Granted, day trading in and out of sector ETFs is indeed speculative behavior. But it’s misinformed to assume tactical trading with sector ETFs is the primary or only way to invest in industry sectors.

Let’s examine three ways sector ETFs can help reduce market risk and increase cash flow.

Spreading Risk

Apple (AAPL) is a recent example of what we’ve witnessed time and again: today’s hotshots becoming tomorrow’s turkeys.

The iPad maker’s stock price has dropped around 40% in value over the past eight months. (Wall Street’s analysts still have a laughable average price target of $633 even though Apple is nowhere near those levels.)

If an investor really believes in the technology sector, why bet the house on just one horse when you can own many?

That’s where ETFs come in.

The Select Sector Technology SPDR (XLK) owns Apple along with Google, IBM and 75 other large-cap technology companies within the S&P 500.

The stock-replacement strategy, with ETFs being used in the place of individual stocks, allows an investor to have broader diversification, less volatility and less single-company risk.

Study after study continues to prove the vast majority of stock portfolios (managed by both amateurs and professionals) consistently underperform corresponding index funds or index ETFs.

This even applies at the sector level. The stock-replacement strategy isn’t just smarter, it also helps investors avoid the higher investment costs associated with those losing strategies.

Increasing Dividend Growth

Bonds or fixed income are a typical source for income-minded investors, but a lack of income growth is a major drawback.

“Unlike the bond market where you receive a set income stream, the beauty of the stock market and dividend flow is the cash paid today with the potential for growth,” said Dan Dolan, director of wealth management strategies at Select Sector SPDRs.

“Many companies are focused on increasing their dividend over time, which results in higher cash flow for investors, making the equity investments more attractive,” Dolan explained.

Higher-yielding sectors like utilities (XLU) have the potential to offer better yields compared to today’s bond rates, but also the potential for increasing dividends.

XLU carries a 12-month yield of 3.72% compared to just 2.72% for TLT, which tracks long-term U.S. Treasuries.

Minimizing Market Distortions

It’s uncomfortable to say, but sometimes traditional market-cap-weighted index funds get distorted.

In 2000, technology shares made up an incredible 35% of the S&P 500’s sector representation. Not only did this minimize the importance of other sectors (the opposite of diversification), it created more sector concentration risk.

Who would’ve ever thought a broadly diversified equity benchmark like the S&P 500 would turn into a top-heavy, tech-dominated index?

By design, equal-weighted indexes or benchmarks aim to reduce these kinds of market distortions. Instead of weighting stock components by their market size, companies are assigned an equal percentage within the index.

The ALPS Sector Dividend Dogs ETF (SDOG) is an ETF that takes a novel approach by applying the “Dogs of the Dow Theory” on a sector-by-sector basis using the S&P 500 as its starting universe of eligible securities.

The fund chooses the top five highest-yielding stocks in 10 different S&P 500 industry sectors and then equally weights each company. This strategy provides diversification at both the stock and sector level.

Although SDOG is less than a year old, the 10-year track record for equal-weighted ETFs like the Guggenheim S&P 500 Equal Weight ETF (RSP) have been impressive compared to traditional market-cap-weighted benchmarks.

SDOG’s current 30-day SEC yield is 3.96%, and dividends are paid quarterly.

Reprints Discuss this story
This is where the comments go.