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So Many Choices!

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It’s easy to become giddy with the growing number of exchange-traded funds (ETFs) and all the investment opportunities that they offer.

Nevertheless, a new obstacle has been created for financial advisors with all of these ETF choices: It takes more time to sort through the maze of options.

Simply put, sifting through and choosing the appropriate funds has become a laborious task.

“The growing number of sector funds means spending longer amounts of time on investment research,” notes Judd Carlton, CFP, with Glassner Carlton Financial in Cedar Knolls, N.J. “If we decide to buy an energy sector ETF we have to ask ourselves whether we want to equal-weight the underlying stocks or whether we want to include energy companies domiciled abroad.”

Nowhere are all of these choices more apparent than with industry sector ETFs.

According to a recent report published by State Street Global Advisors, there’s $61.9 billion invested in sector ETFs, which represents roughly 10 percent of all ETF assets.

In 2005, there were just under 75 sector ETFs. Today, there are almost 200 sector funds. How can you select the right funds for your clients from the myriad of choices?

Know the SceneIt’s important for advisors to understand the ETF market isn’t just a collection of sector funds, but a conglomeration of funds with different index strategies.

Some of the earliest sector ETFs like the iShares Dow Jones U.S. sector funds and Select Sector SPDRs, which were unveiled in 2000 and 1998 respectively, are designed to follow true market barometers. This means the underlying indexes they track are selecting stocks passively and weighting them by market capitalization. ETFs that follow this formula are not trying to beat the market because they are the market.

Around 2006, a new generation of sector ETFs began showing up. It was then that InvescoPowerShares, Rydex Investments and a host of other fund providers began offering a new class of industry sector ETFs, ones that attempt to outperform index ETFs based upon true market barometers. The way they would do this was by using alternative methods for selecting and weighting stocks.

A Lesson in DivergenceIt’s interesting to observe that many ETFs following the same industry sector may own the same exact stocks, but be posting different performance results (see Figure 1). Most ETFs that track a broad basket of technology sectors include Microsoft, Cisco Systems, Dell Computer, IBM and Oracle among major holdings. However, technology ETFs that may own these same stocks don’t all share the same performance, volatility or level of risk.

How is it possible for ETFs that all follow the same exact industry sector to have diverging performance results? The answer can be found by examining what each of the underlying indexes for these ETFs is doing.

The iShares Dow Jones U.S. Technology ETF (IYW), Technology Select Sector SPDRs (XLK) and the Vanguard Information Technology ETF (VGT) all follow market indexes that select technology stocks passively and weight them by market cap. Even though each of these funds is following a different index with a different number of holdings, they all share a common goal of attempting to represent a market of technology stocks. Remember, they aren’t trying to beat a market of technology stocks, because they are the market.

In contrast, the PowerShares Dynamic Technology Sector Portfolio Fund (PTF) and the Rydex S&P Equal Weight Technology ETF (RYT) are using indexes that follow investment strategies, not market indexes. Why would an ETF like PTF decide to select stocks with quantitative filters? And why would it decide to weight those stocks equally? In other words, why would PTF use a methodology completely different than traditional methods, which select stocks passively and weight them by market cap? Same thing goes for RYT. Why would it decide to equally weight each of the S&P’s technology components?

The answer is simple: These funds aren’t trying to match a market of technology stocks; they’re trying to outperform it.

What do your clients want to own? Do they want technology ETFs that represent the market or ones attempting to beat it? If the sector ETFs you choose for your clients are heading in one direction, but the market sectors you thought they were tracking are heading in another, you better have some good answers. If you don’t understand what’s going on inside sector ETFs, how can your clients?

Barclays Global InvestorsBGI offers 23 funds based upon Dow Jones U.S. industry sectors. Stock holdings are passively selected and then weighted by their float-adjusted market capitalization. The composition of the indexes is reviewed quarterly. These particular iShares sector funds attempt to mirror market sectors, not outperform them.

InvescoPowerSharesEach of the 26 Dynamic Sector Portfolios offered by InvescoPowerShares follows indexes based upon investment strategies, not market benchmarks.

For example, the PowerShares Dynamic Technology Sector Portfolio Fund (PTF) attempts to identify the best stocks within the technology sector. Each quarter, 60 stocks are selected from a custom technology universe created using proprietary research. After companies are selected they are assigned a modified equal dollar weight inside the index.

Other PowerShares funds that follow Dynamic Intellidex indexes use a similar investment approach. While the weighting methodology of the stocks is relatively straightforward, the precise formula for stock selection is never fully disclosed. This sort of missing transparency doesn’t occur with ETFs based upon true market indexes.

Merrill Lynch HOLDRs Each of the HOLDRs is a predefined collection of stocks in a particular industry sector. As stocks within a HOLDRs trust merge or disappear, they aren’t replaced or rebalanced. As a result, HOLDRs have the tendency to become concentrated in the remaining stock holdings.

Unlike traditional ETFs, owing HOLDRs is awkward since they can only be purchased in 100-share or round lot increments. If a client wants to buy, say 50 or 75 shares of a HOLDR, he can’t. Also, instead of charging an annual expense ratio, HOLDRs charge a $2 quarterly fee for every 100 shares owned.

The fact that HOLDRs don’t follow any particular index and aren’t managed raises questions about their usefulness as accurate barometers of industry sectors.

For example, the Internet HOLDRs (HHH) is concentrated in only 12 Internet stocks. Noteworthy omissions from this group are Internet juggernauts such as Expedia, Google, IAC/Interactive and Monster Worldwide. Is HHH really an accurate reflection of today’s Internet sector or the one in 2000?

Advisors searching for industry sector ETFs that serve as accurate proxies for the market should avoid using HOLDRs. On the other hand, HOLDRs are a perfect fit for traders that don’t care about anything but volatility.

Rydex InvestmentsRydex offers nine ETFs that follow S&P 500 industry sectors, but with a twist: Stocks within each sector ETF are assigned a fixed or equal weighting as opposed to a traditional market capitalization weighting. By employing an equal weight design, mid- and small-cap stocks aren’t trumped by larger stocks. How does this affect performance? If smaller capitalization stocks are in favor, equal-weighted ETFs are likely to outperform conventional market indexes. Conversely, if large-cap stocks are in favor, expect equal-weighted ETFs to underperform.

Select Sector SPDRsThese nine ETFs which follow S&P 500 industry sectors have been in existence since 1998 and are among the oldest of sector ETFs. They are particularly useful for investors that want to customize their exposure to the S&P 500 index (see Figure 2).

Instead of owning all nine industry sectors as you would by owning a traditional S&P 500 index mutual fund or ETF, you can underweight, overweight or eliminate specific sectors.

The Sector SPDRs follow the same formula as the S&P 500 of passive stock selection and weighting by market capitalization.

Vanguard Vanguard offers 10 industry sector funds based on MSCI indexes. Generally, Vanguard’s sector ETFs tend to be more diversified compared to competing offerings. Interestingly, the firm’s staunch commitment to broadly diversified offerings seems to extend into how it tracks narrow industry sectors.

To illustrate, the Vanguard Financials ETF (VFH) contains 512 stocks, whereas a close competitor such as the iShares U.S. Dow Jones Financial Sector Index Fund (IYF) has 290 holdings and the PowerShares Dynamic Financial (PFI) has just 60 stocks.

WisdomTree InvestmentsWisdomTree offers 10 international-focused sector ETFs. The indexes are derived from the WisdomTree DEFA Index, which tracks dividend-paying companies in developed markets outside of the U.S. and Canada.

Stocks are screened to make sure they pay regular dividends and then index-weighted based on the amount paid. WisdomTree’s ETFs cover a broad range of international sectors including basic materials (DBN), energy (DKA), health care (DBR) and technology (DBT).

Leveraged and Inverse ETFsProShares has 26 sector-focused ETFs that offer leveraged and inverse performance.

One example of a long leveraged fund is the ProShares Ultra Oil & Gas (DIG), which seeks daily investment results that correspond to 200 percent of the daily performance of the Dow Jones U.S. Oil & Gas Index. The ProShares UltraShort Oil & Gas (DUG) attempts to do the exact opposite by providing twice the inverse of the daily performance of the Dow Jones U.S. Oil & Gas Index.

Along similar lines, Rydex Investments recently introduced eight ETFs that offer leverage and inverse performance to S&P 500 industry sectors.

The wonderful performance gains generated by leveraged ETFs can go away just as quickly as they arrived. For that reason, the idea of magnified returns in narrow industry sectors is one that should be utilized with diligent caution.

Points to RememberWhat’s been listed here is not a comprehensive list of all industry sector ETFs. Nevertheless, it will give you a better grip on the supermarket of sector ETFs.

Do not forget that certain ETFs track industry sectors of a particular market. Other ETFs are trying to select only a handful of stocks within a particular sector with the goal of outperforming the market. And other funds use alternative weighting strategies in their attempt to beat the market.

Funds that follow market indexes have lower expense ratios than those following investment strategies. Carlton observes, “We have to be confident that the additional expense for the extra bells and whistles is worthwhile.”

What are other factors that advisors should consider in selecting sector ETFs?

“Advisors should carefully evaluate how these investment vehicles [sector ETFs] fit into their overall investment strategy,” states Dan Dolan, Director of Wealth Management Strategies for the Select Sector SPDRs.

Asking the right questions can help too. How am I using sector ETFs in my client’s portfolios? As core holdings or as satellite positions? And am I increasing or decreasing the overall risk of the portfolio?

Dolan makes one more suggestion: “Make sure the investment portfolio matches the name of the ETF and you get the pure exposure that you expect.”

Ron DeLegge is the San Diego-based editor of