Sector ETFs: Definition & How to Invest

Investing
Updated: 20th Dec 2020
Written by Sean Graytok
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Investing
December 20, 2020
Written by Sean Graytok

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Investing in the stock market is a complex task. However, there are a few investment vehicles worth considering.

Whether you are learning how to start investing or are an experienced investor, there is a time and place for Sector ETFs in your portfolio.

What is a Sector ETF?

Sector ETFs are baskets of securities invested into specific sectors of industry. The securities will be unique to the type of index it tracks, such as a technology or utility index.

For example, the Vanguard Information Technology ETF tracks the performance of the information technology sector.

The global financial community uses the Global Industry Classification Standard (GICS) to categorize the different industries and their subsequent layers.

The structure was developed by MSCI and Standard & Poor’s (S&P) in 1999 and determined that there are 11 sectors, 24 industry groups, 69 industries and 158 sub-industries.

While GICS makes a technical distinction between “sector” and “industry,” these are commonly interchanged.

Related: What is an ETF?

How do Sector ETFs Work?

Understanding the fundamental difference between an index and an ETF helps to see how sector ETFs work.

  • An index tracks the performance of an individual industry
  • An ETF is an actual investment that can be bought and sold

Combining the investment vehicle (the ETF) with the sector-specific index results in the Sector ETF.

While there are many kinds of ETFs, such as bond, international, and currency, they generally work the same way.

Exchange-traded funds trade like stocks on exchanges and have real-time price quotes, unlike their mutual fund counterparts.

Additionally, the holdings of an ETF are often market-cap weighted, meaning that individual stocks with higher market-caps have more pull in the fund.

Moreover, some ETFs track small-cap stocks while others follow large-cap stocks. This added complexity makes it hard for investors to understand what moves an ETF up and to the right.

Invesco QQQ is an exchange-traded fund that tracks the tech-heavy Nasdaq-100 Index.

Here are a few of its holdings and allocations:

  • Apple Inc (13.39%)
  • Microsoft (10.76%)
  • Amazon.com Inc (10.66%)
  • Alphabet A & C Shares (6.73%)
  • Facebook (4.26)

As you can see, just five of the 100 companies in this ETF compose 45% of the entire index.

Instead of owning these individual tech giants, investors may choose to diversify into all of them by using this sector-specific ETF.

Granted, the Nasdaq-100 Index tracks health care and consumer staples stocks too, but one could argue its tech-heavy allocation makes it over-allocated to one industry.

Learn More: Small-Cap Stocks vs Large Cap Stocks

Biggest Sector ETFs (Assets Under Management)

This section will explore how the U.S.-listed sector ETFs rank amongst each other in terms of Assets Under Management ($MM). As of December 20th, 2020.

  • Technology ($334,734.42)
  • Healthcare ($86,639.52)
  • Real Estate ($63,853.14)
  • Materials ($49,923.55)
  • Financials ($46,273.37)
  • Consumer Discretionary ($44,444.18)
  • Energy ($42,969.03)
  • Industrials ($37,466.29)
  • Utilities ($26,651.28)
  • Consumer Staples ($24,395.29)
  • Telecom ($5,442.75)

Leveraged Sector ETFs

Leveraged ETFs use leverage (surprise, surprise) to get multiple times the return of the index they track. For example, if the S&P 500 gains 1% on the day, the ProShares UltraPro S&P 500 gains 3% because it offers 3x daily long leverage on the index. So why are we talking about leveraged ETFs in an Industry ETF article?

Riskier short-term traders often use sector-specific leveraged ETFs to bet on the industries they’re bullish on in the immediate future.

An investor looking to profit on good news from the Biotech space may purchase Direxion’s Daily S&P Biotech Bull 3x Shares to get rewarded three times over on the announcement of a new miracle drug.

However, what goes up 3x, can also come down 3x. This notion leads us to our next topic: Inverse Sector ETFs.

Inverse Sector ETFs

Another instrument investors use to capitalize on sector trends is the Inverse Sector ETF. If someone believes there is a bubble in the technology sector, they may buy an inverse tech ETF to short it. Remember, shorting an asset means you will profit when the asset’s price declines.

Bearish investors may be confident enough to even leverage their inverse play with a ProShares UltraPro Short QQQ. This ETF shorts the tech-loaded Nasdaq-100 Index three times as much as its leverage-free compliment ProShares Short QQQ.

Short at your own risk! Theoretically, an asset can infinitely rise, resulting in unlimited losses for investors that went short.

Sector ETFs Benefits

While we discussed Sector ETFs in detail thus far and highlighted a few benefits, there are still more benefits we have not covered. Remember, most of the underlying benefits of general ETFs also apply to Sector ETFs.

  • Investors can make sector-specific plays based on the status of the industry.
  • Investors can trim off industries that are dragging down the S&P 500 and choose the hot sectors.
  • Sector ETFs are diversified within an industry. But there are levels to diversification.

Mistakes to Avoid when Investing in Sector ETFs

Purchasing too many sectors at once may result in “over-diversification.” Yes, that is a thing. Why buy 11 sectors ETFs and pay each expense ratio when the S&P 500 already captures all the industries?

Here are a few mistakes you need to avoid:

  • Over Diversification
  • Not Accounting for Expense Ratios
  • Unchecked Biases: Make sure you know why you are investing in a sector ETF.

However, investors may achieve an appropriate level of diversification by exploring the 168 sub-industries, such as investing in the semiconductor or Esports space.

Diversification is unique to each investor and is ultimately determined by their goals and risk tolerance.

How to Invest in Sector ETFs

#1 Choose a Broker

We are fans of Vanguard and Charles Schwab for exchange-traded funds. These are the godfathers of discount stock brokers and will surely have every ETF under the sun.

More Options: Best Online Stock Brokers

#2 Fund Your Account

Vanguard and Charles Schwab ensure your money makes it safely from your bank into your new brokerage account.

It’s as easy as linking your bank and determining the amount of cash you want to deposit. The two common methods of deposits are ACH payments and wire transfers.

#3 Pick Your Sector ETFs

This is the fun part. Be sure to do your own research and not fall victim to FOMO. Or do. Some bull markets last much longer than anticipated and buying at all-time highs is better than never buying at all.

Related: Stock Market Research Websites & Motley Fool Review

Bottom Line: Sector ETFs

For investors, Sector ETFs offer diversification, safety, and exposure to multiple industries all at once. This is why ETFs have triumphed over individual stocks in recent years.

ETFs make it easy for new investors to safely invest their money and reap the benefits of healthy growth over a long period.

Sean Graytok
Sean Graytok
Sean is a lifelong student of the financial, media, and marketing industries. He is a Generation Z investing expert and is on a mission to empower investors to make the most of their money.