Among the first ETF’s to be created were sector specific ETF’s created by State Street (their ETF’s are more commonly known as Spiders) and that was for a very logical reason. Economists have known for decades that some sectors react much better depending on the state of the economic cycle. It is easy to understand why. Someone fearing for his job or in an unstable financial situation might cut down on certain expenses (luxury items, travel, etc) but will probably spend more or less the same amount at the grocery store or the pharmacy. But of course, taking advantage of such a situation was very tricky. You could always buy one or two companies in the sector but that makes it an unprecise investment.

Then came ETF’s of course and it instantly became fairly easy to make sector investments. The first player not surprisingly was Ishares which launched 9 sector ETF’s. They remain the largest and most liquid sector ETF’s on the US market and while many alternatives now exist, they are the easiest way to play sector over & underperformance. Going long a specific ssector is one of the obvious bets bvut even hegde funds and sophisticated investors were able to make long/short investments betting not on one sector but rather on one doing better than another.

So I wanted to do more research into Sector ETF’s, how much diversification they provide, if they really work, and the possible options. I would love to get some feedback and any comments from investors who are or were active in sector ETF investing.

What are sectors

Sectors of the US economy are done in a fairly simple manner. All economic activity that contributes to the GDP was divided into different parts. Depending on who does it, you will have a slightly different number of sectors but the 9 selected by State Street are the ones we most generally see when hearing about sectors. That being said, any of these sectors could easily be divided back into smaller subsectors. Sectors will generally:

-Relate to a different part of the economy
-React differently in periods of decline (recessions), expansion and growth
-Depend on different variables (interest rates, employment, etc)
-Together, they represent the entire private economy

So the 9 sectors, which will be explained later are:

-Consumer discretionary
-Consumer staples
-Energy
-Financial
-Health Care
-Industrial
-Materials
-Technology
-Utilities

Why sectors

Why invest in sectors then? There are many reasons to do so, the main ones in my opinion are:

–Diversification: No matter what your portfolio includes, it has a bias, and under certain circumstances, the portfolio will perform poorly. When you have a good feeling that these conditions are coming up, you can do one of two things. Either you sell and modify your portfolio (which can result in capital gains taxes, costs for rebalancing, etc), or you can do a hedge. Going into a recession, you could keep your portfolio but simply invest in a sector that generally performs well in such a climate such as “Consumers staples”, etc.

–Theory: According to basic economy, each economic cycle favors a few specific sectors. For someone investing with a more “economic perspective”, sector ETF’s can provide countless opportunities if you can have a better vision than the market regarding economic movements.

Counter-argument

However, what I was wondering was if it really worked. Why wouldn’t it? Well, to start off. I agree 100% that some sectors will always perform better in a recession while others will do better in good times. But if investors are always anticipating these changes, it’s not clear to me that these company performances would be reflected in the stock market.

Reality?

What I did find on Spider’s website was very interesting, take a look at the following chart comparing the returns of the different sectors to the S&P500 as a whole. My first conclusion would be that indeed, there is a lot of diversification when you look at the range of returns experienced. However, some of the individual sectors have surprising results in my opinion. For example, why is Consumers Discretionary doing better than Consumer Staples in such a poor economy? Is it because consumers are feeling things getting better and going back to restaurants, etc? Surprising…. I also would have expected a stronger performance from the health care although maybe the recent health reform had an impact.

Plenty of options by sector

Consumer discretionary: Industries such as automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media. The obvious choice here is XLY but as you can see there are many alternatives or more precise investment possibilities

Consumer staples: These are all purchases made by consumers for necessary items, usually anything related to food, beverages, tobacco, household products. As you can imagine these are fairly recession resistant but would not increase that much during an economic boom.

Energy: Primarily develop and produce crude oil and natural gas, and provide drilling and other energy-related services

Financial: This includes perhaps the most famous sector ETF as XLF was a major investment during the financial crisis



Health Care: Fairly obvious pick. Health Care is everything surrounding medications, doctors, hospitals, etc.

Industrial: Industries in the Index include aerospace and defense, building products, construction and engineering, electrical equipment, conglomerates, machinery, commercial services and supplies, air freight and logistics, airlines, marine, road and rail, and transportation infrastructure companies

Materials: Chemicals, construction materials, containers and packaging, metals and mining, and paper and forest products

Technology: If you are here, you know what technology represents. There is an increasing number of options within the technology sector!

Utilities: companies involved in water and electrical power and natural gas distribution industries