Sign up today and take advantage of member-only content — the kind of timely, cutting edge industry insight that only Money Management Executive can deliver.
  • Exclusive Online Only Content
  • Free Daily Email News Alerts
  • Asset Management Blogs

Sector ETFs: Know What You're Buying

When it comes to sector exchange-traded funds, know what you're buying.

There are all kinds of industries, all kinds of ways to structure the components of funds and a wide variety of ways to capitalize - or not - on a given part of the economy, according to investment researchers at Charles Schwab.

The universe of sector-based exchange-traded products is about 300, according to Michael Iachini, managing director, ETF Research, Charles Schwab Investment Advisory. Some sectors, such as communications, only have eight or ten products. Real estate counts some 30 ETFs. The energy sector has more than 50.

"If you start looking at ways at using these ETFs, you basically have two different approaches. One is more strategic. If you're an investor and you have stocks and want to round out your portfolio to fill in the gaps, a sector ETF can be a good way to do that," he said in a media call this month.

"The other way investors use ETFs is tactical,'' he said. "They'll look at sectors and look at what's likely to outperform and underperform. And if a sector looks undervalued, they might take part of their asset and out that into a sector ETF, specifically to benefit from that shorter-term view."

With any investment or sector, Iachini advised investors to: "Know what you're buying because you don't know exactly what it is until you dig into the ETF."

And why does it matter so much for sector ETFs? Iachini said it's because there's so much variety even within a single sector. For example: Within the energy sector, you might find an ETF that just invests in oil and gas equipment companies, or within the financial sector you might have an ETF that just invests in banking stocks.

Also, those same sector ETFs may also have different flavors in terms of having exposure to U.S. large cap stocks, small cap stocks or international stocks. "You'll also find some emerging market stock ETFs and a few single country ETFs like the China financial sector or the Brazil technology sector," said Iachini.

There is also a variety of indexes that sector ETFs track including simple market-cap weighted, fundamental-weighted, quantitative-weighted and equal weighted indexes, according to Iachini.

Costs vary, as well. "Talking about expense ratios, the basic large cap U.S. sector ETF tend to cost somewhere in the neighborhood of 20 basis points but in some of the emerging market sectors you might be paying 85 bps," said Iachini.

"Not every sector ETF is going to be easy to trade and liquid. If you look at the bid/ask spread, you can see some spreads as wide as 1% or 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. So if you're using these ETFs on the short-term approach, those spreads are going to really add up."

Fund managers also must be careful to balance their holdings, said Eric Pollackov, managing director for ETF Capital Markets at Charles Schwab.

"ETFs that are registered under the '40 Act structure cannot hold more than 25% of a single security and a combined total of all positions greater than 5% cannot compromise more than 50% of the portfolio when it's rebalanced,'' he said. "In between times of rebalanced periods, there can be times when a single security goes greater than 25%."

Assets being held in sector ETFs as of the end of May are relatively flat year-to-date among Schwab clients, according to Pollackov. Currently, sector ETFs account for 13% of the ETF asset at Charles Schwab and capture about 18% of net flows year-to-date.

"Real estate ETFs captured the most flow year-to-date and I think a lot of those have to do with yields and interest rate environment that we're currently in," he said. "Financial ETFs had the strongest asset growth [year-to-date] at around 23% due partly to strong inflows but also to the low valuations of those stocks at the end of last year. In the consumer, defensive, communication and utilities were the only sectors that had negative flows [year-to-date] and their asset growth has been relatively flat as well."

In 2012, there has been a lot of "risk-on, risk-off type trading, rather than specific sector fundamentals being focused on,'' said Brad Sorensen, director of market and sector analysis, Schwab Center for Financial Research.

"Concern has grown in the economy and what's going on in Europe,'' he said. "It's been a little frustrating for some sector investors because a lot of the underlying fundamentals have returned to being largely ignored and the focus is now on the major macro things that we've seen."