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What is a sector ETF and how to invest in them

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There are many different types of ETF’s and sector ETF’s were created to enable investors to invest in certain sectors of the economy.  This gives investors more ability to make more focused investments in a group of businesses that operate in similar areas of the marketplace.

The most commonly listed sectors are the 11 sectors of the S&P500; index.  Dow Jones and MSCI (Morgan Stanley Capital International) back in 1999 decided to classify companies of the S&P500; into similar areas of business and called it the Global Industry Classification Standard (GICS).   Here they are below:

  • Communication Services                                                              
  • Consumer Discretionary
  • Consumer Staples
  • Energy
  • Financials
  • Health Care
  • Industrials
  • Materials
  • Real Estate
  • Technology
  • Utilities

Each of these can be further grouped into industries.   The weightings of these sectors within the S&P 500 index can change over time depending on the growth of the underlying companies and which companies get added or removed from the S&P 500 Index annually.

There are additional ETF sector funds that different asset management companies have created to allow investors to make a specific investment in certain areas of the market.   These are sectors such as Artificial Intelligence, Cannabis stocks, or metals such as Gold and Silver to name a few examples.  In cases like this, the term Sector ETF is broadly used as a focused area of the market.

Leveraged ETFs

Leveraged ETFs were created to give investors the ability to magnify returns in certain areas of the stock market without having to add additional cash.   Proshares and Direxion Funds are 2 companies that have created these types of investments.  These ETFs will have 2x or 3x in their name indicating the amount of increase or decrease in returns to expect versus the base case investment.  These ETfs do have higher volatility and higher risk so do your research before investing.

Inverse ETFs

Inverse ETF’s increase in value when the area of the market it represents declines such as a sector or even the general market like the S&P500;.  Basically, the return of these inverse ETF’s will move in the opposite direction of the underlying sector.   This can be used to offset or hedge against a loss in an existing investment or it can be used to increase profits from a decline in a sector of the market where an investor doesn’t have much exposure already.

Buffered ETFs

Buffered ETFs can be good investments for people nearing retirement that are more concerned with downside protection than high returns.  These ETF’s have been created in the past few years mostly by insurance companies.   Basically, they utilize options within the ETF to help protect against some losses.  The option positions can be expensive to implement so the ETF will have a cap on the amount of positive return an investor can achieve in a given period of time usually a year.   There are a few different companies that are now offering these types of ETF’s and each have different amounts of risk and return profiles so an investor needs to do additional reading on what might be right for them.

MLP ETFs

MLP stands for Master Limited Partnerships and are typically created for companies that distribute natural resources such as oil or natural gas pipelines. The structure of the partnership requires these companies to distribute a large portion of their earnings annually which can give investors an income stream.  Some MLP ETFs may also hold investments of other natural resources as well such as timber so its important for investors to look into the best MLP ETF for them.

Using sector ETFs in your portfolio

Sector ETFs can be a good way to complement an existing well-balanced portfolio.  A common portfolio construction strategy is called Core-Satellite.   Using this strategy, a majority of your investments would be in a well-balanced diversified portfolio of stocks and bonds and the remaining amount would be invested in some satellite holdings, such as Sector ETFs, based on your views as to which investment markets will perform better in the near future.  If you have a view that Cannabis stocks may do well or Gold may do well then you have the ability to make sure you have some dedicated investment in these sectors to complement your Core Portfolio with these additional investments.

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Debra Ohstrom, CFA is an online course creator who uses her financial expertise to empower women to take control of their financial future.

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