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ETFs: How to Combine Style and Sector Strategies

Using sector ETFs can be a great way to diversify your portfolio. It also, however, can be dangerous if you use this strategy as a means to help you speculate on the market.

When to prefer the style grid for your ETFs

There is nothing wrong with dividing up a stock portfolio into industry sectors, but please don’t be hasty in scrapping style investing. If you’re going to pick one strategy over the other, the edge still goes to style investing. For one thing, we know that it works. Style investing helps to diffuse (but certainly not eliminate) risk. Scads of data show that.

In addition, style investing allows you to take advantage of years of other data that indicate you can goose returns without raising your risk, or raising it by much, by leaning your portfolio toward value and small cap.

When you invest in industry sectors through ETFs, you are most often investing the vast majority of your funds in large caps, and you’re usually splitting growth and value evenly. That approach may limit your investment success.

Another reason ETF investors shouldn’t scrap style investing: Style ETFs are the cheaper choice. For whatever reason style ETFs tend to cost much less than industry-sector ETFs. On average, they’re about half the cost. Go figure.

And one final reason to prefer style to sector for the core of your portfolio: You will require fewer funds. With large growth, large value, small growth, and small value, you pretty much can capture the entire stock market.

With sector funds, you need nearly a dozen funds to achieve the same effect. Each sector fund offers minimal diversification because the price movements of companies in the same industry sector tend to be closely correlated.

How to combine strategies to optimize your ETF portfolio

There’s no point to having dozens of ETFs in your portfolio if they are only going to duplicate each other’s holdings. So if you already own the entire market through diversified ETFs in all corner quadrants of the style grid — large, small, value, and growth — why add any industry sectors that are obviously already represented?

It would make sense to add a peppering of semiconductor stocks or utility stocks if you knew that semiconductors or utilities were going to blast off. (Of course, a rational investor would never say he or she knew anything about the future, other than that the sun will probably rise tomorrow.)

And yet, taking on an added dose of semiconductors or utilities may still make sense if that added dose of either industry sector somehow were to raise your performance potential without raising risk. That could happen only if you chose an industry sector that is not closely correlated to the broader market.

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