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How to Diversify Your Sector ETF Investments

Using sector ETFs to diversify your portfolio can be an advantageous strategy. An in-depth study on industry-sector investing, done several years ago by Chicago-based Ibbotson Associates (now part of Morningstar), came to the very favorable conclusion that sector investing — because times have allegedly changed — is potentially a superior diversifier to grid (style) investing.

Globalization has led to a rise in correlation between domestic and international stocks; large, mid, and small cap stocks have high correlation to each other. A company’s performance is tied more to its industry than to the country where it’s based or its market capitalization, concluded Ibbotson.

The Ibbotson report didn’t end there. It also ballyhooed sector investing as a superior instrument for fine-tuning a portfolio to match an individual investor’s risk tolerance. A conservative investor might overweight utilities (a less volatile sector); a more aggressive investor might tilt toward technology (whooeee).

That sounds like a good plan, although the lead author of that study once said that he has the bulk of his personal portfolio still broken up into value, growth, large cap, and small cap. However, he has some industry-sector ETFs (for fine-tuning), as well.

How to calculate your optimal sector ETF mix

If you are going to go the sector route and build your entire stock portfolio, or a good part of it, out of industry-sector ETFs, before you do anything, take a look at the breakdown of the industry sectors. Make sure you are able to have allocations to all or most major sectors of the economy.

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Some advisors would tell you to keep your allocations roughly proportionate to each sector’s share of the broad market. That’s decent advice, with just a bit of caution: Had you taken that approach in 1999, your portfolio would have been chocked to the top with technology, given the gross overpricing of the sector at that point. (And you would have taken a bath the following year.)

No matter what sectors are hot at the moment, no single sector should ever make up more than 20 percent of your stock portfolio.

Start perhaps with roughly allocating your sector-based portfolio according to the market cap of each sector, and then tweak from there — based not on crystal ball predictions of the future but on the unique characteristics of each sector.

Seek risk adjustment with high and low volatility sector ETFs

Some industry sectors have historically evidenced greater return and greater risk. (Return and risk tend to go hand-in-hand.) The same rules that apply to style investing apply to sector investing. Know how much volatility you can stomach, and then, and only then, build your portfolio in tune with your risk tolerance.

Keep in mind that any single sector — even utilities, the least volatile of all — will tend to be more volatile than the entire market because there is little diversification. Don’t overindulge!

Finally, keep in mind that your allocation between bonds and stocks will almost certainly have much more bearing on your overall level of risk and return than will your mix of stocks.

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