Industry ETFs, Perfect for Following Sectors

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Most major sectors of the market (finance, biotech, energy, etc.) have a correlating index. For example, the gold sector has the XAU index. The automotive industry has the AUX index. Each index consists of equities that fall into a certain industry. The insurance sector index (IUX) consists of major insurance company stocks. So, if investors want to gain exposure to a certain industry, they can buy an index basket which covers the major securities in the sector.

What Is an Industry ETF?

An industry ETF tracks an industry index. The goal of the ETF is to mimic the performance of the correlating industry index, but not outperform it. An Industry ETF usually consists of the same securities as the correlating index. However, instead of buying individual equities to fulfill an index basket, it is a single block trade. Due to this difference, the makeup of the ETF may differ from the makeup of an index basket, but the allocation of the assets in an ETF should be similar enough to match the performance of the index it tracks.

What Is the Advantage of an Industry ETF Over an Industry Index?​

When trading an index basket, there can be a few difficulties. Trying to acquire a certain price is not an easy task since you are trading multiple products. Stocks move, sometimes in the wrong direction. If using a limit order, you may have to wait to get all of the stocks in the basket. If using a market order, the market price may be higher or lower than expected. Also, due to trading multiple securities per basket, commissions tend to be a little higher when trading indexes.

A lot of these difficulties can be eliminated by trading an industry ETF. Since an ETF is one single product, you can buy or sell it with one trade. That makes it easier to acquire a target price as well as keeping commission fees down.

What is the Advantage of an Industry Index Over an Industry ETF?

If you are trading index options, an industry ETF is not the perfect hedge. While in some cases it can be used to offset risk, the prices of index options are based on the index basket, not the ETF. Also, clearing firms will not consider your portfolio hedged if the countermeasure is an ETF and not the index basket. If using an ETF as a hedge, you may have to keep more money in your account to offset risk.

Index baskets tend to change. Sometimes it is the amount of shares of certain equities in a basket, other times it is the actual stocks themselves. So if using an index basket as a hedge for derivatives, you can easily adjust the amount of shares in your basket account to line up pricing. With an ETF you don’t have that freedom. You’re at the mercy of the ETF issuer to make the appropriate adjustments. In some cases, you may be able to make the adjustment yourself, but that requires more trading, more commission charges, and may make things confusing for your portfolio.

However, some ETFs do list options, so an investor has the choice of trading industry index option or industry ETF options in certain sectors.

Why Should I Include Industry ETFs in My Portfolio?

If you are an investor looking to gain exposure to a certain industry (bearish or bullish), you can play that sector with just one single transaction. You can buy or sell and industry ETF. Is oil too high? Sell an oil ETF. Is home construction going to turn around? Buy ITB, a home construction ETF. With one trade an investor can have a vested interest in a certain market sector.

Another reason to buy or sell an industry ETF is to hedge risk. Maybe your portfolio has a high percentage of pharmaceutical stocks and the current economic climate worries you. A possible solution would be to hedge your position by selling the IHE, a pharma ETF.

Before you call your broker to trade an industry ETF, it is very important to conduct thorough research and analysis. A good place to start is by looking at some of the major industry ETFs and watch how they perform. Or if you have a certain sector in mind for your investment strategy, watch the indexes and ETFs for that industry.