How to use ETFs for sector investing?

Sector investing can add to higher diversification score for your portfolio. It can also help in capitalizing on the opportunities that arise because of the changing nature of consumption and growth patterns in the economy. For example, in the late 90s technology in general and the Internet sector in particular was a hot sector. When Greenspan unleashed the easy money policy of early and mid 2000s the home builders and housing were a hot sector to invest in. It is true that the housing sector of the economy took a hit in the the Great Recession, but it seems to have come back in the current expansionary cycle of the economy. Even though there are reports that rising home equity since the last recession has not had the same level of impact on consumer spending as it had in the last cycle.

When it comes to sectors most people think of the following sectors of the economy. Technology, Consumer Discretionary, Consumer Staples, Energy, Financials , Health Care, Industrials, Materials, Utilities. These also correspond to S&P500's 9 sectors. One can also think of Biotech as a separate sector. Would you consider social networking as a sector or just a industry within the technology sector? These and other such questions are something an investor might want to keep in their mind.

If you have a view on a particular sector and want to act on that view with a limited amount of capital to put at risk, what would you do? Would you buy individual stocks in that sector? This would give you no diversification and your risk would be too much. What if the company you chose turns out to have a crooked management and it ends up restating earnings, that would be a very bad situation for your investment portfolio, to say the least. Instead if you put that capital to work in an ETF, you will get instant exposure to your favorite sector with all the associated benefits of an ETF: low expense ratio, diversification, intraday trading (what if you change your mind, and decide to sell the investment at a moment's notice), and less taxable events compared to similar mutual funds.

Expense ratios on S&P 500 sector ETFs are less than 0.20%. The 9 sector ETFs for S&P 500 are: Consumer Discretionary: XLY, Consumer Staples: XLP, Technology: XLK, Energy: XLE, Financials: XLF, Health Care: XLV, Industrials: XLI, Materials: XLB, Utilities: XLU. Other ETFs to consider are in biotech sector such as SPDR S&P Biotech ETF: XBI. XBI has almost 2.5 Billion dollars indexed into it. It has a higher expense ratio of 0.35%. The Health care is another sector to consider given the baby boomers retirement equation. If you are not sure if a given ETF in its category has the best combination of low expense ratio and high asset base, you could go to ETFscale's Mutual Fund To ETF Converter tool and input an ETF or mutual fund to find similar ETFs. The word similar here means in the same category. The table that is output will show a list of similar ETFs in ascending order of expense ratios. It will also show you the asset base for each ETF in the table.

In the future blogs we will consider how to incorporate a sector ETF in your asset allocation strategy.

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