How to Use Industry ETFs to Follow Certain Sectors
An exchange-traded fund (ETF) invests in a collection of stocks, bonds, and other securities often designed to track a specific index. ETFs differ from mutual funds because they are listed and sold on stock exchanges at market prices.
Industry and sector ETFs track a specific industry or sector index. For example, an ETF designed to track the S&P 500 Health Care index would be expected to perform similarly to that specific index.
- Industry ETFs track specific indexes associated with sectors of industry.
- Unlike mutual funds, ETFs trade at market prices like publicly traded stocks.
- They provide a way to invest in an entire industry with one product.
- Associated fees mean their returns sometimes can underperform their target indexes.
What Are Industry ETFs?
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.
How Do Industry ETFs Work?
Each industry ETF will include detailed information about its benchmark sector and index, its major holdings, its ticker symbol, fees, historical performance, and more. For example, the Vanguard Information Technology ETF trades under the symbol VGT and specifies that it "Seeks to track the performance of a benchmark index that measures the investment return of stocks in the information technology sector."
Investors can buy and sell ETFs much like they would buy and sell any publicly traded stock.
Because ETFs are bought and sold at market prices, this particular ETF can be tracked by looking up the symbol VGT. Further research into the product will show that, as of September 2020, it includes 330 stocks with a median market cap of $235.4 billion. Its top two holdings are Apple and Microsoft.
Industry Indexes vs. Industry ETFs
Industry indexes are a representative snapshot of a particular industry. Basically, it is a means of gauging and tracking market performance for an industry as a whole. An industry ETF is an actual investment that can be purchased or sold, and it increases or decreases in value due to typical market factors.
Indexes are based on specific combinations of individual assets. Fact sheets associated with indexes include a breakdown of the underlying assets, historical performances, and more, and they can be found on the websites for those specific assets. Industry ETFs typically will have holdings similar to what the indexes are tracking. As well, these holdings can be found on fact sheets available from the fund manager.
Pros and Cons of Industry and Sector ETFs
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 and limit commission fees. For example, if you want to invest in technology stocks, you could invest in a single technology ETF as opposed to buying and trading multiple technology stocks individually.
ETFs protect you from the potential volatility of individual stocks, but fees or tracking errors can cause ETFs to sometimes underperform the indexes they are designed to mirror.
While investing in a single ETF may be easier than juggling multiple stock holdings individually, it also limits your flexibility as an investor. The underlying assets are determined by a fund manager, so if you want the ability to increases or decrease your holdings in the underlying assets, an ETF probably isn't for you.
How to Invest in Industry ETFs
ETFs are much like any other investment product. Working through a brokerage, you select the ETFs you want to add to your portfolio and how much to invest. As with any kind of investment, research is important. For example, utility sector ETFs typically are more stable than technology sector ETFs, so it's important to consider that and other similar factors when developing your overall investment strategy.
Avoid ETF duplication by investing in a combination of ETFs that all serve a different purpose based on your needs and goals. For example, investing in a broad mix of Industry ETFs serves little purpose if you already have diversified holdings through other types of ETFs.
One approach is a rotation strategy. This bases your investment approach on predictable cycles associated with economic conditions. For example, different sectors are more or less likely to outperform the market depending on the overall state of the economy. In this strategy, you would shift the focus of your EFTs to the most favorable sectors based on the current state of economic growth.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.