Everything You Need to Know About Sector ETFs

Everything you need to know about ETFs is this article.

You will learn:

• What sector ETFs are
• The different types of sector ETFs
• Benefits & risks of sector ETFs
• Bottom Line: Should you invest in sector ETFs?

This article provides important details regarding each of the 11 sectors of the stock market, as well as information on sector ETFs that investors can use to invest in these various niches.

What Are Sector ETFs?

Before we delve into what sector ETFs are, we must first recognize that there are 11 distinct industry sectors within the stock market: technology, health care, financials, real estate, energy, materials, industrials, consumer discretionary, utilities, consumer staples and telecommunication.

A sector ETF is like an ordinary ETF in that it’s a pooled investment. Contrary to tracking an overall stock market index, however, sector ETFs seek to mirror the performance of a specific industry within the overall stock market. For example, a sector ETF that’s focused on the health care industry would have a basket of stocks and securities that operate in that field.

Types & Examples of Sector ETFs

• Technology – This sector is dependent on the overall health of the economy as well as upgrade cycles for electronics manufacturers, information technology companies and software companies.

• E.g. Google, Apple and Microsoft

• Health Care – This sector is a safe investment since medical assistance is essential to the livelihoods of people, and it consists of medical device manufacturers, biotechnology companies, hospital management firms and pharmaceutical companies.

• E.g. CVS Health, Anthem and UnitedHealth

• Financials – This sector’s growth is dependent on mortgages and loans that rise in value as interest rates climb, and it consists of banks, investment management firms and insurance companies.

• E.g. Visa, Mastercard and JP Morgan Chase

• Real Estate – This sector’s value is based on real estate appreciation, and similar to the financials sector, it is also dependent on interest rate increases. It consists of industrial, retail and residential property management companies.

• E.g. Weyerhaeuser, Equity Residential and SBA Communications

• Energy – This sector’s profitability is dependent on commodities such as natural gas and oil appreciating at price. It consists of gas and oil production companies, power/energy companies and refineries.

• E.g. ExxonMobil, Chevron and General Electric

• Materials – This sector is dependent on the overall supply chain, so the business cycle and overall health of the economy are essential to this sector’s performance. It consists of mining companies, refineries and any company that is involved in the discovery, research and development of raw materials.

• E.g. United States Steel Corp., Steel Dynamics Inc. and Sylvamo Corp.

• Consumer Discretionary – This sector relies on consumer spending, which ties into a healthy economy. Thus, it consists of retailers, apparel companies, media companies, etc.

• E.g. Home Depot, McDonald’s and Nike

• Industrials – This sector is reliant on the demand for the construction of buildings, as well as the growth of agriculture. It consists of companies operating in the defense, construction, manufacturing and machinery fields.

• E.g. Plug Power Inc., FedEx and Waste Management

• Utilities – This sector consists of electric, gas and water companies that charge consumers recurring payments.

• E.g. American Electric Power, Enbridge and Duke Energy

• Consumer Staples – This sector consists of food and beverage companies operating in the restaurant business, and it is a safe investment like health care because it’s essential to consumers.

• E.g. Procter & Gamble, Campbell Soup Co. and Albertsons
• Telecom – This sector consists of internet service providers, cable companies, mobile carriers and satellite companies. Similar to the utilities sector, its profitability is based on recurring payments from its consumers.
• E.g. AT&T Inc., Verizon Communications Inc. and T-Mobile US Inc.

Below is a short list of sector ETFs that you can explore, as well as an example from each of the 11 sectors:

• Technology – XLK (Technology Select Sector SPDR Fund)
• Health Care – VHT (Vanguard Healthcare ETF)
• Financials – KRE (SPDR S&P Regional Banking ETF)
• Real Estate – IYR (iShares U.S. Real Estate ETF)
• Energy – TAN (Invesco Solar ETF)
• Materials – GDX (VanEck Gold Miners ETF)
• Consumer Discretionary – FXD (First Trust Consumer Discretionary AlphaDEX Fund)
• Industrials – JETS (U.S. Global Jets ETF)
• Utilities – PAVE (Global X US Infrastructure Development ETF)
• Consumer Staples – IEV (iShares Europe ETF)
• Telecom – NXTG (First Trust Indxx NextG ETF)

Benefits & Risks of Sector ETFs

Perhaps the biggest benefit of sector ETFs is being able to invest in an entire industry without having to pick individual stocks to add to one’s portfolio. Therefore, if an investor believes that the technology sector, for example, has high prospects for performing well, they can just invest in a technology ETF such as XLK rather than research what stocks in that industry to buy. Overall, it’s a great way of gaining exposure to sectors that investors are optimistic about but are uncertain about individual stock positions within it. For example, if an investor is uncertain about whether to pick Lockheed Martin, Northrop Grumman or Raytheon, then ITA and XAR (two Aerospace and Defence ETFs) are both great sector ETF alternatives. Similarly, Investors who don’t know whether to buy shares in Pfizer, Abbvie, Merck or some of the many other pharmaceutical companies, they can just buy VHT (Vanguard’s Healthcare ETF).

On the contrary, sector ETFs also are riskier investments than conventional ETFs and mutual funds because the basket of stocks caters to only one particular industry. This doesn’t allow for much diversification because if an economic event were to negatively impact the respective industry, the entire fund would do poorly. Thus, the biggest con to investing in sector ETFs is limiting diversification in one’s portfolio. However, investors who are very familiar with the economy and are confident in predicting economic events can use sector ETFs to their advantage. An example would be going into a recession in which the consumer staples sector would do very well relative to other sectors.

Bottom Line: Should You Invest in Sector ETFs?

Sector ETFs provide more diversification than buying individual stocks. For investors who really want a specific asset allocation model to add to their portfolios, these funds are ideal. This is because some investors like to bet on certain sectors of the economy doing better than others due to macroeconomic trends, politics, etc. Furthermore, ETFs overall are less volatile than direct stocks, and it’s easier to hold them with a long-term perspective to avoid the short-term capital gains tax.

However, the big drawback of these funds is the fact that if an economic event were to negatively affect a sector, the entire fund wouldn’t perform well, so many sector ETF investors often times invest in multiple sectors due to this limitation in diversification.

Overall, these funds require investors to do research on the prospective sectors they’d like to invest in and stay up to date with economic trends to capitalize on them.