What it means
The fund holds a basket of listed insurers, which may include life insurers, property and casualty insurers, reinsurers and insurance brokers. Some funds track a published index of insurance stocks and simply copy it, while others pick holdings using their own rules.
Investors buy and sell its shares on an exchange throughout the day. Insurance companies earn money in two main ways.
They collect premiums, which are the payments customers make for cover, and keep the part not needed for claims and costs, and they invest the premiums they hold until claims are paid. This second source, called investment income, means insurers are sensitive to interest rates.
When rates rise, insurers can generally earn more on new investments, which is often positive for profits, although falling bond prices can reduce the value of what they already hold. Large disasters, such as storms and floods, can cause a spike in claims that hurts the earnings of property insurers.
A sector fund captures these effects across many companies at once. For a business, the practical uses are modest.
A treasury team or pension scheme might use the fund to gain sector exposure without the work of analysing each insurer, and an advisor might use it to rebalance a portfolio that is under-weight in financial companies. The costs are mainly the fund's expense ratio, which is the annual fee as a percentage of assets, and the small difference between the buying and selling price.
A narrow sector fund also concentrates risk, since a regulatory change or a bad catastrophe year can hit most holdings at the same time. Investors should also read what the fund actually holds.
A fund may be dominated by a handful of large companies, or it may have a large share of one sub-sector such as health insurance, so the name alone does not describe the exposure.
In practice
Real-world examples.
Example
A retired engineer wants to invest in financial companies but does not know which insurers to pick. He buys an insurance sector ETF and gains exposure to dozens of insurers for a single, low annual fee.
Example
A portfolio manager expects higher interest rates and decides to increase exposure to insurers that benefit from higher investment income. She uses a sector ETF to make the change within a day, without trading each stock individually.
Example
A financial adviser notes that a client's portfolio is full of technology shares. She adds an insurance ETF to spread risk, because insurers' earnings depend on different factors such as claims and interest rates.
Formula
Calculation
Annual fund cost = Amount invested x Expense ratio
An investor puts $50,000 into an insurance industry ETF with an expense ratio of 0.40%. The annual cost is 50,000 x 0.0040 = $200.
If the fund's value rises by 6% over the year before costs, the gain is 50,000 x 0.06 = $3,000. After the fee of $200, the net gain is 3,000 - 200 = $2,800. Fees are deducted inside the fund, so the investor sees them as a slightly lower return rather than as a separate bill.Case study
Seen in the real world.
Lakemont Family Office is an illustrative, fictional investment office managing $30 million for a family. The investment committee felt the portfolio had too little exposure to defensive sectors, which tend to hold up better when economic growth slows.
The analyst proposed placing $1.5 million, or 5% of the portfolio, in an insurance industry ETF. She explained that insurers earn steady premium income and that the fund's 0.40% annual fee would cost 1,500,000 x 0.004 = $6,000 a year.
The committee approved the plan but asked for the fund's top ten holdings to be reviewed every quarter. In this illustrative story the review soon showed that one-third of the fund was in just three companies, which led the family to cap its total insurance exposure to avoid overlap with a stock it already owned directly.
Watch out
Common mistakes.
- Assuming a sector ETF is diversified like a broad market fund, when it is concentrated in one industry and moves with it.
- Ignoring overlap, such as owning the same large insurers through both the ETF and a separate stock holding.
- Judging the fund by its name alone without reading its holdings and the index it tracks.
Questions
People also ask.
What drives the performance of an insurance ETF?
It is mainly affected by claims experience, interest rates, investment markets and regulation, all of which affect insurers' profits.
Can an ETF hold insurance brokers as well as insurers?
Yes, depending on the index, some funds include brokers and reinsurers alongside the companies that write the policies.
How is an ETF different from a mutual fund?
An ETF trades on an exchange throughout the day at a market price, while a mutual fund is bought and sold at its end-of-day value.
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