ETF Trends
ETF Trends

In today’s world, there are many active managers who employ domestic exchange traded fund (ETF) sector rotation strategies as a means to obtain relative value. But far fewer investors seem to be willing to dive below the surface to target industry groups.

There are obvious reasons why some investors stop at the sector level and avoid industries altogether. First, there are many more industries than sectors, which makes obtaining research and evaluating industry investments a bit more complicated and costly than rotating exclusively at the sector level. Using the S&P 500 as an example, there are ten sectors, but over 150 sub-industries. So if you want simplicity, then sector investing may be the better bet.

Another reason that some shun industry exposure is that sometimes an investment in an industry can be viewed as too concentrated a bet versus its sector counterpart. A good example might be the homebuilding industry, which is a part of the consumer discretionary sector and easily investable by ETF (XHB/ITB). The industry is such a small part of the sector (approximately 1.5%) that investors buying the homebuilders instead of discretionary stocks are making a very material bet versus the benchmark. Some investors simply don’t like the idea of getting that far off the benchmark, which can be understandable depending on the investing mandate of the manager.

A final practical reason why some avoid industry investing is that not all sub-industries are available at the ETF level. True, there are far more choices than ever before, but the reality is that not all sectors are created equal. At present, there are some great choices of industries for some sectors (e.g., Technology, Financials, Healthcare, Energy), and others where the primary exposure is limited to the sector itself (e.g., Staples, Utilities, Telecom Services).

Clearly, making the jump to analyze and rotate industries versus sectors is not for every investor, and there are added layers of research that one must commit to before deciding to put industries on the investing menu. The industry bet versus the sector may seem attractive for a multitude of reasons such as valuation differentials, technical considerations, the macro and micro economic landscape, politics, geopolitics, etc. There is clearly homework for the investor to do, and a lot to consider when investing at the industry level. But for those willing to put in the work, there can also be handsome rewards.

To illustrate how big those rewards can be, consider an investor who was excited about the long term prospects for the biotechnology industry ten years ago, and was forced to decide whether to invest in the healthcare sector or the biotechnology industry. For simplicity, we’ll say the investor had two ETF choices at that time: the overall healthcare sector ETF that contains a benchmark weighting of biotechnology stocks (XLV) or an equal-weighted index of biotechnology industry stocks (XBI). One look over a decade’s time will give a sense for the return differences that can be generated by investing industries versus sectors.

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