Definition of “Sector ETF”
An ETF class that invests in stocks and marketable securities of a particular sector, i.e., pharmaceuticals, energy, industry, technology, IT, consumer goods or finance. Most of these ETFs focus on U.S. based stocks, however many can invest globally in an effort to capture the worldwide performance of the given sector.
Assets are passively managed around an underlying index; many ETFs use indexes provided from data services like S&P 500 and Dow Jones. Leveraged sector ETFs also are out there, that aim to attain double the comeback of the underlying index, each on advancing and declining trading days.
Explanation of “Sector ETF”
Sector ETFs from various industries such as Pharma ETF, Tech ETF, Banking Sector ETF, Financial ETF, IT ETF, etc. help diversify the portfolio and investment strategy.
Sector ETFs are Exchange-Traded Funds (ETFs) that track the performance of a specific sector. The reason that economists and investors are grouping companies into similar sectors of the economy is logical. After all, these companies face similar preconditions and challenges, and will most probably develop in a similar way within a certain period of time.
Take, for example, the pharmaceutical sector ETF. A pharmaceutical group may own a better drug in one area, or produce something more effective for some reason, the industry sector as a whole is subject to the same laws and regulations, has the same cost of raw materials, etc. and therefore will be roughly moving in the same direction.
What makes Sector ETFs so interesting?
Sector ETF strategy allows investors to invest in the specific developments of a sector. With the purchase of an ETF, you can invest in the entire sector, without having to put together a basket of stocks from that industry yourself.
For example, investing in the pharmaceutical sector with iShares US Pharmaceuticals ETF. The five largest holdings in the index are Johnson & Johnson (JNJ) with 10.20%, Pfizer Inc. (PFE) with 8.74%, Merck & Co Inc. (MRK) with 7.84%, Bristol Myers Squibb with 6.45% and Eli Lilly with 6.14%.
Sector strategy of Real Estate ETFs "Select Sector SPDR Fund" is experiencing a big Inflow in the recent times.
Before sectors were created, ETFs had to invest in the pharmaceutical sector, the investor had an option to buy even the individual shares of various companies, to choose and buy in the desired quantities.
This was not only difficult but also time-consuming and very expensive, unlike sector mutual funds.
Another investment advice would be to invest in an actively managed health care fund. However, the fees are much more expensive here than in the case of passively managed ETFs.
Sectors ETFs are flexible, easy to trade, and with its help, you can invest in multiple market sector, rather than simply diversifying your portfolio by region or country.
Market Rotation Strategy
Sector ETFs are great for implementing a Market Rotation Strategy. This is a very interesting and successful sector strategy approach, also called market rotation in short.
The starting point for this strategy is a market-wide stock index, which replicates different sectors or sectors with varying weights.
Subsequently, a statistical relationship between the observed objective factors at the beginning of a quarter, and the actual performance of the sector at the end of the quarter is first found for each sector using past values.
The established relationship is then used as the base for assessing the performance potential of each sector over the next three months.
Factors influencing the estimation include:
- Interest rate level
- Price-earnings Ratio
After the performance potential of the individual sectors has been estimated, a corresponding ranking list will be prepared. An optimization process will then be followed by a weighing of the sectors with the highest risk-adjusted return expectations.
In doing so, the current sector weightings of the benchmark index may be increased or reduced by a maximum of 5%.
Finally, the most representative stocks are selected for the representation of the individual sectors. This selection is based on the highest positive earnings outlook revisions based on 12-month general agreement forecast published by Thomson Financial I / B / E / S ®.
In each sector, the selected stocks are weighted equally.
In simple words, the basic idea is to give more weight to sectors where you expect the best profit in the next phase of the business cycle. Or select the one overweighted in the long run, wherein long-term the best outcome in the portfolio is suspected.
For example, one can expect fairly that the global population will continue to grow, and at the same time, energy consumption will also increase, which means that Energy ETFs can be given more weight within the portfolio.
How does Sector ETFs work?
Like other ETFs, sector ETFs track a particular index and are managed by an index provider:
The "Industry Classification Benchmark" (ICB): This classification scheme is based on 75,000 securities. These are divided into 10 industries, 19 super-sectors, 41 sectors and 114 sub-sectors.
The Global Industry Classification Scheme (GICS): This classification scheme is based on 51,000 securities divided into 11 sectors, 24 industrial groups, 68 industries and 157 sub-industries.
Basically, both methods are pretty similar to each other. The MSCI indices are based on the GICS system, while the industry indices of STOXX Ltd. are based on the ICB system.
Both approaches follow the same logic. The hierarchy is based on broad industry groups, which are then subdivided further, and further down to small niche areas.
For example, if a company generates the majority of its revenue from the aerospace industry, the shares will be allocated to the category "Transport" according to the ICB scheme. This, in turn, belongs to the Aerospace Sub-Sector, which in turn is part of the aerospace and defense sector. This Sub-Sector is also a part of the Super-Sector, which is in the Super-Group "Industry".
ETFs of the best industries take advantage of the impact of the business cycle. Indeed, sector ETFs encompass the most important securities in a particular industry and track their performance.
As some industries make higher profits over the course of the business cycle, Sector ETF investors can logically benefit from these developments as well.
Sector ETFs rarely track the performance of an underlying index, as the "normal" ETFs (bond ETFs, commodity ETFs, etc.) does. Sectors ETFs rather summarizes the price of various securities from a particular industry. These industries include:
- Aerospace and Defense
- Industrial Goods
- Real Estate
- Health Care
- Natural Resources
Sector ETFs Providers
The State Street Global Advisors Company is one of the world's largest asset managers (approximately $2.0 trillion assets under management).
In Germany, over 80 ETFs are traded by SSgA under the name Spider Index Funds (Spider, in short) at German Stock Exchange. The offered ETFs represent both national and international indices based on market capitalization, investment style, and sector.
Example: SPDR MSCI World Industrials UCITS ETF
Industry: Industrial Goods
The MSCI World industrials is an international stock index, reflecting the performance of industrial goods equities in world’s 23 developed countries.
You must never lose sight of the costs when creating. For example, annual fees are slightly higher than regional or country-based ETFs. With sector ETFs, with a relatively low fund volume, higher costs may arise.
Also keep in mind that a market rotation strategy does not buy the entire market, but basically takes an active approach and invests in a small group of companies looking for positive overall performance, good market cap, and high total return.
In order to beat the cheaper indices, which are weighted by market capitalization, you have to be pretty correct with the assessment of this type of ETF. With a wrong decision, your investment will develop significant losses.
Despite possible risks, the benefits seem to outweigh Sector ETFs. Because the sector rotation strategy is proven well in practice and relatively successful when properly executed. Sector ETFs are a great way to accommodate the laws of business cycles.