What it means
An exchange-traded fund (ETF) is a fund that holds a basket of investments and whose own shares can be bought and sold on a stock exchange throughout the day. A sector ETF narrows the basket to one sector.
Most track an index of companies in that sector, so they simply follow it rather than trying to beat it. The appeal is simplicity and diversification within a sector.
Buying one technology ETF gives a stake in dozens or hundreds of technology companies, so one company's failure matters less. Fees are usually lower than for actively managed funds, and the holdings are published so investors can see what they own.
Sector ETFs are widely used to express a view or adjust a portfolio. An investor who expects health care to do well can add a health care ETF, while a manager who is overweight in one sector can trim it with a single trade.
Businesses with surplus cash invested in markets may also use them for tactical positioning. There are risks to understand.
A sector ETF is concentrated, so it can fall sharply when its sector is out of favour. Some are also dominated by a few very large companies, which means the fund may be less diversified than the number of holdings suggests.
Costs should be checked before buying. The expense ratio is the annual fee charged as a percentage of the amount invested, and the bid-ask spread is the small gap between the buying and selling price.
For small investors, the fund's trading volume and tracking quality matter as well. Tax and structure add some nuance.
In many countries, ETFs can be more tax-efficient than traditional funds because of how shares are created and redeemed. The rules differ by country and account type, so investors should check how gains and dividends are taxed in their own situation.
In practice
Real-world examples.
Example
A retail investor believes the health care sector will do well. She buys $5,000 of a health care sector ETF instead of picking individual stocks. Her money is spread across many companies, and she can sell during any market day.
Example
A pension fund manager is underweight in energy compared with the benchmark. To correct this quickly, she buys $2,000,000 of an energy sector ETF. She can later replace it with individual holdings if she wishes.
Example
A small business owner invests spare company cash in a diversified portfolio and adds a utilities ETF to reduce risk. Utilities tend to be steadier in downturns. The ETF's low fee keeps the cost of the position small.
Formula
Calculation
Annual fund cost = amount invested x expense ratio
An investor puts $20,000 into a sector ETF with an expense ratio of 0.10% and compares it with an actively managed sector fund charging 0.60%. The ETF costs $20,000 x 0.0010 = $20 a year. The active fund costs $20,000 x 0.0060 = $120 a year, so the ETF is cheaper by $120 - $20 = $100 each year.Case study
Seen in the real world.
Birchwood Family Office is a fictional adviser with a client who wanted exposure to renewable energy but had no time to research individual firms. The adviser, Kamal, recommended a sector ETF holding a broad group of renewable energy companies.
The client invested $100,000 and paid a low annual fee. Over the following year the sector was volatile, and the ETF fell by 18% in one quarter before recovering part of the loss. This is an illustrative story, but it makes the point that a sector ETF gives diversification across companies, not protection from the sector itself, so Kamal limited the position to a small share of the client's total wealth.
Kamal also explained that the fund's top five holdings made up about 40% of its value. That meant the ETF's results depended heavily on a handful of large companies, which the client had not expected when he first read the fund's name.
Watch out
Common mistakes.
- Believing a sector ETF is fully diversified. It spreads risk across companies but remains concentrated in one sector.
- Ignoring what the ETF actually holds. Two funds with similar names can have very different top holdings and weightings.
- Chasing last year's best sector. Performance in one period does not guarantee that the pattern will continue.
Questions
People also ask.
What is the difference between a sector ETF and a broad market ETF?
A sector ETF holds one part of the economy, while a broad market ETF holds companies across all sectors.
How do I buy a sector ETF?
You buy it through a brokerage account in the same way as a share, and the price changes throughout the trading day.
Are sector ETFs good for long-term investing?
They can be used that way, but their concentration means they are often used for targeted views or portfolio adjustments rather than as a single core holding.
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