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This time of the year is full of investment predictions for the New Year. These expectations typically run the gamut from an extension to new all-time highs versus the apprehension of the next bear market cycle. Yet, sprinkled in between are numerous calls for individual sectors that are expected to outperform in the current market environment.
For instance, ETF.com recently interviewed David Mazza, vice president and head of research for SPDR ETFs and SSgA funds, on his sector picks for 2016. His top recommendations included numerous sound reasons to own the SPDR S&P Regional Banking ETF (KRE), SPDR S&P Homebuilders ETF (XHB), and Technology Select Sector SPDR (XLK). The full text of this interview can be accessed here.
These forecasts are generally built on solid technical or fundamental themes that should provide a tailwind for specific areas of the market. Oftentimes they are predicated on the continuation of an existing trend or the expectation of a reversal given new data or emerging themes.
One of the risks of owning a niche industry or sector ETF is that it can significantly underperform a more diversified basket of stocks such as the Vanguard Total Stock Market ETF (VTI). Forecasts are simply educated guesses based on experience or historical data that are far from guaranteed to being effective.
With that in mind, these tips should help you improve your investment success with individual sector funds.
Sector Strategy Session
The hit-or-miss risks in individual sector picking make these vehicles more appropriate for intermediate to experienced investors. The more concentrated nature of the underlying indexes makes these funds more susceptible to volatility within their corner of the market as well. Nevertheless, these ETFs are attractive for those seeking to boost the performance of their portfolio above a diversified equity benchmark.
The proliferation of sector ETFs by numerous fund sponsors has created a strong menu of varying indexes to consider. Keep in mind that index construction will be a big determining factor in the overall performance of the fund. Common index methodologies include market-cap weighted, equal weighted and factor weighted. Each variant has its own strengths and weaknesses that should be examined in the context of your investment thesis. In addition, the underlying expense ratios and liquidity of these ETFs vary greatly.
ETF investors should treat sector funds as tactical opportunities rather than core building blocks. This means that position sizes should be kept small or moderate in order to maintain a reasonable exposure that doesn’t overcommit your portfolio to a single outcome. If you treat a sector ETF like an individual stock, it becomes easier to integrate these holdings within the context of your overall portfolio.
The use of transaction-free ETFs at several of the most popular online brokers may be one of your best resources in this arena. The elimination of trading fees will allow you to add or reduce exposure to specific sectors in small increments as needed. This reduces friction and creates greater flexibility to make adjustments over time.
Furthermore, it may behoove you to select several (3 or more) sectors with the expectation that you may have one or two misses in the group. This will help further diversify your holdings and enhance the chances that you will pick a fund that significantly outperforms its peers.The motto “don’t put all your eggs in one basket” comes to mind when constructing an allocation to sector ETFs.
The Bottom Line
The low cost and transparency of exchange-traded funds make for an excellent way to invest in specific corners of the market. However, sector investing should be approached in a conservative nature that is used to complement or enhance an already diversified portfolio.
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