Sector ETFs: The Next Hot Industry - dummies

By Russell Wild

One danger of ETFs is their ability to allow you to easily purchase into sectors, which can be dangerous when it leads to speculation. There’s little question that people who divide their portfolios into large/small/value/growth are much more likely to be long-term investors with long-term strategies than are people who buy into sectors.

Will your chosen sector ETF perform?

Sector funds are often purchased by investors who think they know which sectors (or sectors within specific countries, such as financials in Brazil) are going to shine, and goshdarnit, they’re going to profit by it. Unfortunately, they are often wrong.

There was once a day when environmental service companies, by dint of the realization that pollution was becoming a serious problem, were going to be a sure bet. But then, lo and behold, environmental service companies seriously lagged the overall market for years.

Then it was information technology that couldn’t possibly fail to outperform, yet for three brutal years (2000–2002), the technology sector fell like hail. Presently, the materials sector is the one that people are pouring money into. Who knows what the next big market will be?

ETFs for momentum riders and value investors

Interestingly, while most investors are momentum investors — they tend to buy what’s hot — other investors look for what’s not, on the theory that everything reverts to the mean. The two camps are forever trading sector funds back and forth.

Right now, the momentum investors are buying materials and energy; the bottom feeders (who prefer to see themselves as value investors) are buying financials and housing construction. Fortunately (or unfortunately), there is no dearth of ETFs to please both crowds.

Note: That is not to say that neither momentum investing nor buying up down-and-out industries has value. Both strategies have been known to make money. But such strategies can’t be done helter-skelter. Like any other kind of investing, they require careful thought and study. Many rapid sector traders are not such deep thinkers.

You can tell that sector speculation — or speculation of any sort — is risky. But what about using sector ETFs as buy-and-hold instruments? Even though few people do it, can a buy-and-hold portfolio be just as easily and effectively divided up by industry sector as it can by investment style? It is possible to do sector investing right, just be careful.