risk and reward

Sector ETFs are Relatively Cheap, but Still Carry Risks

risk and reward

In what seems like both a blessing and a curse for retail investors, exchange-traded funds offer the ability to invest in thin equity market slices cheaply relative to traditional sector mutual funds. According to Morningstar, the average sector mutual fund carries a 1.72% expense ratio, while a recent Morgan Stanley report pegged the average sector ETF expense ratio at 0.47%.

Although this is good news for investors who like to make sector bets, the majority of academic research shows that retail investors are generally horrible market timers. Although ETFs allow investors to make cheap and easy sector investments, the funds carry special risks that must be understood. We'll also look at the pros and cons of an all-ETF portfolio comprised of several sector funds versus holding a single broad market ETF.

Exchange-traded funds generally undercut comparable mutual funds in terms of expenses.

Average Expense Ratio
Major market ETFs
Style ETFs
Sector ETFs
International ETFs
All ETFs
Traditional Mutual Funds
Average Expense Ratio
Active Domestic
Active International
Passive Domestic
Passive International

Source: Morgan Stanley Equity Research
*doesn't include HOLDRs, which charge $2 per quarter per 100 share lot, if covered by dividends
The most heavily traded ETF and the second largest, the Nasdaq-100 Tracking Stock (QQQ), is in many ways essentially a technology sector fund. The fund holds the largest 100 stocks traded on the tech-dominated Nasdaq, with a 67% weighting in technology according to Morningstar.

State Street Global Advisors offers a lineup of sector funds in the Select Sector SPDRs, which break down the S&P 500 by industry. Barclays Global Investors counters with sector iShares based on the Dow Jones Total Market Index. Finally, Merrill Lynch's HOLDRs are another way to get sector exposure with a single trade.

Thus far, ETF managers have marketed sector ETFs as a cheap way to build a diversified portfolio. The only problem is that in most cases a broad market fund, such as the iShares Dow Jones U.S. Total Market (IYY) or SPDR 500 (SPY), would get the job done cheaper and easier. For even broader exposure, the Vanguard Total Market Vipers (VTI) tied to the Wilshire 5000 are another attractive option.

The main argument for constructing a sector ETF portfolio is that it allows an investor to tilt the portfolio to certain industries. Aside from the dismal market timing record of individual investors, chasing hot market segments through sector ETFs also generates unwelcome taxes and broker transaction costs.

"By shifting around in ETFs frequently, short-term capital gains can eat up a lot of your excess return," said Morningstar analyst Peter Di Teresa. This of course assumes an investor is a successful market timer, and most are not especially over long time periods.

One scenario where a sector ETF portfolio might make sense is for the investor who owns a large stake of company stock within his or her industry. For example, imagine a technology company employee who has a significant stock options package. A broad ETF such as the iShares S&P 500 (IVV), which has over 17% in technology, would cause tech overlap within the portfolio. In this case, it might be feasible to build a tailored portfolio of cheap sector ETFs minus technology to increase diversification and reduce risk.

However, Di Teresa points out that a broad market style ETF might be a cheaper alternative (see table above). For example, a tech-light value ETF could do the trick for most investors without the headache of investing in several funds.

Finally, Di Teresa noted that many sector ETFs are highly concentrated and may end up behaving more like individual stocks than funds in terms of volatility. Many of the sector ETFs and HOLDRs are dominated by a few names and oftentimes the top ten holdings comprise a significant amount of assets. For example, Technology Select Sector SPDRs (XLK) have nearly 60% of assets in the top ten holdings according to Morningstar, with 15.4% of assets in one stock - Microsoft - alone.