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Sector ETF Diversity

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Sector funds are a temptation few investors can resist. With investment-oriented websites and cable news programs now unleashing a constant barrage of data regarding housing starts, retail sales and oil inventories, it seems like second nature to fine tune any portfolio with allocations to various industries or economic sectors that appear poised to grow (or contract) over the coming years.

Sector funds offer investors exposure to a specific industry or sub-industry, while minimizing “company risk,”–the potential for shares in a company to fall while others in the same industry are rising due to company-specific factors. They don’t always follow general trends in the stock market, and are often considerably more volatile.

Hundreds of mutual funds already exist, offering exposure to different sectors of the U.S. and global economy, and the number of exchange traded funds set up to track sector indexes is growing quickly. There were 233 “sector/industry” ETFs trading at the end of April, 2009, according to Investment Company Institute data, more than the 201 broad-based equity funds or the 211 global or international equity funds.

Sector ETFs have both advantages and disadvantages compared with similar mutual funds. Like other ETFs, their expense ratios tend to be very low, usually from 0.4% to 0.7%, compared to a range of 0.7% to more than 2.0% for sector mutual funds. Also, since they trade all day long, sector ETFs can be bought and sold in reaction to new market data–which is usually released early in the day–while mutual fund transactions are given an end-of-day price.

The massive upheaval in the banking sector helped land three financial sector ETFs: Direxion Daily Financial Bull 3X (FAS), Financial Select Sector SPDR (XLF), and Direxion Daily Financial Bear 3X (FAZ), in the top five among trading volume for ETFs over the past three months, according to Yahoo data. (Leveraged sector ETFs, such as FAS and FAZ, have important differences from unleveraged sector ETFs that may affect returns significantly. S&P will write more about that subject in this space next month.)

Real estate sector ETFs have been extremely popular recently, as a means for investors to place bets on the future of the U.S. housing market.

Sector ETFs come in a fairly wide variety, from broad sector exposure to extremely narrow. Within energy, for instance, ETFs that cover the entire energy sector (oil and gas producers, equipment and service companies, coal producers, etc.), are available, such as Energy Select Sector SPDR (XLE), and iShares Dow Jones U.S. Energy Sector ETF (IYE). Others are focused on just one of the industries making up the energy sector.

Transaction costs, however, can erode the cost advantages sector ETFs enjoy over sector mutual funds if they are purchased in small quantities on a regular basis, such as when investors use dollar cost averaging. Making a single investment, however, may be appropriate with a sector ETF, but it’s worth bearing in mind that the prospects for individual sectors ebb and flow, and choosing the right exit point may well be a key factor in achieving the desired return.

Since one of the benefits of buying sector ETFs is the exposure to smaller stocks within a particular industry, it may make sense to consider sector ETFs that are “equal-weighted.” Most ETFs are “capitalization-weighted,” meaning the largest companies make up the fund’s largest holdings. With an equal-weighted ETF, however, the fund holds the same amount of each individual index component regardless of their relative size. Equal weighted funds tend to outperform capitalization-weighted funds during times when small-cap stocks outperform large cap stocks. Rydex offers several sector ETFs that are equal-weighted. (This table lists cap-weighted and equal-weighted ETFs for each sector, excepting telecommunications, where no equal-weighted ETF exists; the S&P technology index incorporates telecom stocks.)

S&P Senior Financial Writer Vaughan Scully can be reached at [email protected]; send him your ideas for Wealth Manager‘s ETF Expert e-newsletter story topics.

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