As the popularity of the exchange traded funds (ETFs) investment vehicle grows, more investors are taking a shotgun approach to investing by picking out whole sectors of the market for their investment portfolios.
There are around 760 ETFs on the market, with 140 aimed at domestic industries that range from nine broad categories all the way down to narrow niche themes, writes Bob O’Brien for Barron’s. According to State Street Global Advisors, about $30 billion has been invested into S&P categories in 2009 alone, up $2.5 billion in 10 years. (6 ETFs everyone should know).
Sector-based ETFs provide an appealing investment idea that many investors want: maximum returns with lower risk. Many advisors also see that these ETFs have the potential to produce more stable alpha, or outperformance, than a strategy of sifting through stocks in a sector. (Which is better – picking stocks or ETFs?)
Other favorable characteristics of sector ETFs include reduced volatility, diversification across a specific industry and liquidity, especially in shorting a sector when shorting individual stocks in the sector isn’t an option. (How sector ETFs can enhance your portfolio).
Doug Sandler, chief equity officer at Riverfront Investment Group, says sectors where the median of the performance range varies from the mean performance, or “wide-dispersion” areas, offers stock pickers opportunities to add value. When dispersions are wide, the chance of picking an individual winner is low and that’s where ETFs come into better use.
When choosing sectors, first consider your options. As stated above, there are broad sector ETFs, such as the iShares Dow Jones U.S. Transportation Average (NYSEArca: IYT), and there are narrower sub-sector ETFs, such as the Claymore/NYSE Arca Airline (NYSEArca: FAA). Bear in mind that the narrower you get, the more volatility you could encounter.
Pick your spots by watching the trend lines – the 200-day moving average can signal to you when to be in and when to be out. The ETF Trend Following Playbook has more on this strategy.
For more information on market sectors, visit our sector category.
Max Chen contributed to this article.