Sector ETFs, as the name implies, are comprised of stocks in a specific economic sector. Here are some examples:
It’s important to understand that sector ETFs don’t usually contain all stocks in a specific sector. A sector ETF is comprised of stocks chosen by the fund’s issuer, which is usually a large financial institution. Sector ETF issuers may build a portfolio to track a narrow-based index, or they may assemble a basket of stocks according to what they consider to be a representative sampling of that particular sector. In other words, someone will actually have sat down and determined which stocks best represent a sector and which ones don’t.
It’s the components of the ETF and their weighting in the fund which will impact how the price of the sector ETF will change. Some sector ETFs may be evenly weighted across a large number of companies, and others may be overwhelmingly concentrated in one or a small handful of stocks (which can significantly increase the ETF’s volatility). Still other ETFs may hold futures, hard commodities or other investments in addition to stocks. ETFs with the goal of tracking the same sector, or even the same narrow-based index, are likely to hold different investments with different weightings. So it’s very important to closely examine the structure of an ETF before you trade it.
Also, make sure you’re clear on the difference between a sector and an industry. For instance, High Flyer Search is in the technology sector, and so is Chips R Us. However, High Flyer Search is a big player in the internet industry, whereas Chips R Us makes computer chips and is in the semiconductor industry. Be sure to make the distinction whether you want to trade an entire sector or stay focused on a particular industry.
When you buy a sector ETF you’re expecting bullish activity in a specific sector. Regardless of your expectations, the market can always behave counter to what you intend. Owning a sector ETF can result in losses if the ETF declines in value. The steeper the decline, the greater the loss will be. There are many reasons you may like the prospects for a particular sector, such as regulatory changes in the industry, upcoming news events, seasonal events, etc. However, you should also keep sector rotation in mind as you evaluate sector ETFs.Sector rotation
It’s a given that the economy moves through different cycles, performing well at certain times and not so well at others. Although there are no guarantees, history has shown that certain sectors tend to perform better or worse depending on where we are in the current economic cycle.
Sector rotation is an approach to investing that involves the active buying, selling and possibly shorting of securities in particular sectors based on whether the economy is in a state of growth, peaking, declining, bottoming out, or resuming growth all over again.
For example, when the economy is booming sectors that have historically performed well include automobiles, financials, retail and housing. In periods of economic bust, sectors that tend to have better profits than others include food and beverage, healthcare (particularly the pharmaceutical industry), and utilities. These sectors that perform well in bad economic times are often referred to as “defensive sectors” because they contain companies which provide goods or services people need no matter what’s happening in the broader economy. (Defensive stocks have nothing to do with the defense sector, by the way.)
Sector rotation may sound quite simple in theory, but the tricky part is determining exactly where the economy is in its cycle. There are two reasons for that. First, economic cycles do not tend to adhere to a specific schedule. Second, the data that enables us to determine exactly where we are in these cycles tends to lag by several months or even longer. An investor who successfully engages in sector rotation will have to be better than most in recognizing the signs that changes are coming in the broader economy. If you decide to pursue sector rotation as an investment strategy, then research the subject in depth to help you better understand the key indicators that may herald changes in the economic cycle.
Please note: If you use a sector ETF in a market timing strategy, this may involve frequent trading, higher transaction costs, and the possibility of increased capital gains that will generally be taxable to you as ordinary income. Market timing is an inexact science and a complex investment strategy.
Sector ETFs are traded across all time frames, from the very short-term (like news-related events) to the very long-term (“buy and hold” for long-term growth or for a sector rotation strategy). Your time horizon may vary according to your investment objectives, skill level, risk tolerance and available capital. Bear in mind: The more frequently you trade, the more transaction costs you will incur.
When to Get In
You might consider going long a sector ETF if:
- You expect an upcoming seasonal event to boost profits in your sector. You may decide to buy the sector ETF before the favorable season begins. For instance, if you expect holiday shopping to be much stronger than usual, you might consider buying a retail sector ETF during the fall.
- There are bullish technical indicators setting up for the sector ETF.
- There is an upcoming news event, such as a regulation change, that the marketplace expects to spark growth in your sector.
- Using sector rotation, this is a sector or industry poised for growth coinciding with the next phase of the economic cycle
When to Get Out
Long sector ETF holders might sell their positions based on any of the following:
- You’ve reached your profit target. Don’t get greedy. Get out before the ETF reverses.
- Your predetermined stop–loss has been triggered.
- There are bearish technical indicators setting up for the sector ETF.
- If you have run this strategy as a shorter-term trade in anticipation of a run-up to a positive news event, it’s oftentimes a good idea to exit the trade before the news is released, since holding onto the position through the event may involve too much uncertainty.
- There is an upcoming news event related to your sector that is expected to be unfavorable.
- Your sector is entering a season or regulatory climate that may prove difficult.
- Using sector rotation, this is a sector or industry expected to face challenges in the next phase of the economic cycle.
- You’ve given the ETF adequate time to perform, and it’s not demonstrating much in the way of bullish activity. Stick to your planned timeframe.
Just because you’re in the trade doesn’t mean your hard work is over. It’s just begun. If any of the analysis used to get into your trade shows signs of trouble, take action to reduce or exit your position, if warranted.
This is a trade where you really have to keep an eye on the news. Make sure you pay attention to the Wall Street sites and tune in to the financial channels, watching for news events pertaining to the sector. If you catch a whiff of rumors that sound unfavorable to that sector, it may be time to bail on the trade.
Any time you enter a trade, you are obviously expecting the results to be outstanding. But as you know, that will not always be the case. Even the most carefully chosen trade can go south in a hurry, resulting in losses.
If your trade is a winner, don’t get greedy. Get out. Take your gains and move on to the next trade — unless, of course you have very good reason to remain bullish. At this point maybe you use a stop-loss order but perhaps “tighten the leash” on the trade to minimize how much could be given back to the market if there’s a downturn in the sector. Even if you’re still bullish, at least consider selling some portion of your position to lock in those gains. You can exit the rest as you see fit if you think the market is stagnating or going lower.
Keep in mind that you need to have realistic objectives. When you’re trading sector ETFs you shouldn’t expect your money to double over the course of a few months. You are also very unlikely to hit the high point of a rally. By trying to milk a trade for every last percentage point, time and again investors have given back too much of their gains. Don’t be one of them.
In general, it’s a better idea to have a predefined stop-loss, stick to it like crazy glue on flypaper, and get out fast when your trade first starts going south. Don’t rationalize or make excuses; sell the ETF. If the sector turns around and goes on a bullish run later, don’t kick yourself. Just stop getting quotes on it and move on to the next trade.
Sector ETFs will tend to behave in a less volatile manner than the average stock. However, they will tend to be more volatile than broad-based index ETFs which track the S&P 500. That’s because broad-based index ETFs consist of nearly all sectors, and different sectors will tend to react differently to market events. Stocks within the same sector will tend to react in a manner similar to one another because they’re a similar kind of stock, so there is less of a balancing force at work.
Furthermore, if the sector ETF is overwhelmingly comprised of one or a small handful of stocks, that will ramp up the volatility significantly compared to an ETF that is equally balanced across a large number of companies. However, even though an ETF may have lesser volatility than another investment, it does not mean it is low risk.
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required. If you understand the risks, long sector ETFs can be purchased on margin as long as you have a margin account which meets the minimum equity requirement of $2,000. The initial margin requirement is usually 50% of the purchase price and the maintenance requirement is usually 30% of the current value. These requirements could increase due to market volatility, fluctuations in the ETF’s value, concentrated positions, trading illiquid or low-priced securities and other factors. Certain restrictions may apply if there is abnormal volatility in your sector. Margin trading involves risks and is not suitable for all accounts.
Investments in sector exchange-traded funds may impact your tax liability, sometimes in ways you may not expect. Read Basic Strategies with ETFs and consult your tax advisor for the low-down on this important topic.