What Is a Sector ETF?

Sector ETFs Explained

Woman looking at a stock market graph on a laptop screen
•••

sarote pruksachat / Getty Images

A sector ETF is an exchange-traded fund in a specific industry or sector that offers the diversification of mutual funds and the trading benefits of stocks. A sector ETF follows a variety of selected stocks within an industry by tracking an index, instead of the broader market.

This guide will explain everything you need to know about sector ETFs, how they work, whether they’re a smart investment, alternatives to them, and how to start investing in sector ETFs.

Definition and Examples of Sector ETFs

Sector ETFs invest in the stocks and securities in a given industry sector. This allows you to track the market performance of some of the top companies within a particular sector. You can opt for sector ETFs in all major U.S. sectors.

A few popular sectors include:

  • Information technology
  • Industrials
  • Energy
  • Health care
  • Transportation or industrials
  • Real estate
  • Materials
  • Utilities

Sector ETFs may be referred to as industry ETFs, although this is not common.

How Sector ETFs Work

Sector ETFs allow you to invest in an entire industry and typically, track major indexes (such as the Standard & Poor’s 500) within a given industry. When you purchase an ETF, you do not own shares in a company. Instead, the fund originator owns the assets, creates a fund to track a particular index, and sells fund shares to investors.

With an ETF, you can trade shares like you would stocks, but receive the diversification benefits of a mutual fund.

ETFs are often considered safer investments than stocks, but they may yield lower returns. Sector ETF performance will vary, depending on the industry you select.

Types of Sector ETFs

There are 11 sectors you can invest in with sector ETFS, shown here with their Select Sector Standard & Poor's Depository Receipt (SPDR) ETF ticker, or trading, symbols. They are:

  • Energy: XLE—companies that develop energy
  • Materials: XLB—companies that manufacture raw materials
  • Communication Services: XTC—telecommunications and transmitting companies
  • Industrials: XLI—construction, aerospace, industrial machinery, waste management, tools, and metal fabrication companies
  • Consumer Discretionary: XLY—companies in the non-essential goods industries
  • Consumer Staples: XLP—companies that manufacture and distribute primary goods such as food, household supplies, beverages, and other essential items
  • Health Care: XLV—manufacturers of health and medical care items, drugs, and health services providers
  • Financials: XLF—companies involved in providing financial services such as mortgages, loans, banking, and consumer finance offerings
  • Technology: XLK—companies producing software, hardware, or internet-related programming
  • Real Estate: XLRE—companies involved in buying and selling property
  • Utilities: XLU—companies delivering and transporting energy to residences and businesses

Alternatives to Sector ETFs

Sector ETFs offer varied stability, depending on which industry you select. Many investors opt to own ETFs across all or a few major sectors. While sector ETFs can round out a well-diversified investment portfolio, alternative options could include broad index ETFs, market index funds that follow the S&P 500 or the Dow Jones Industrial Average (DJIA), and mutual funds.

Investing directly in stocks is another option that can sometimes yield higher returns. However, stock investing can require more of a time commitment because you’ll need to follow company financial performance and projections closely, and be ready to sell or buy as dictated by the market. Stocks are also riskier investments.

Pros and Cons of Sector ETFs

Pros
  • Tax benefits

  • Less risk

  • Easy to research

  • Good diversification options

Cons
  • May have high fees

  • Single-sector ETFs limit diversification options

  • Lower returns

Pros Explained

  • Tax benefits: Most sector ETFs only incur taxes at the time of sale of the investment, unlike mutual funds, which incur tax burdens during the lifetime of the investment.
  • Less risk: Sector ETFs are generally seen as less-risky investments, particularly when spread across multiple industries.
  • Easy to research: If you’re new to investing, sector ETFs will feel less alien than some stock types because the industries will likely be familiar and the companies involved are usually easy to understand and research.
  • Good diversification options: If you choose to spread your money across several top-performing sector ETFs, you can build out a well-diversified portfolio.

Cons Explained

  • May have high fees: While ETFs generally have low fees, because you’ll purchase them through a trading partner, be prepared to pay higher commission fees and trading costs than with individual stocks.
  • Single-sector ETFs limit diversification options: If you only invest in one industry, you’ll be limiting your chances to diversify.
  • Lower returns: While ETFs are generally considered safer investments, returns can be fairly predictable and less exciting than stocks.

Are Sector ETFs Worth It?

Investing in a variety of sector ETFs can be a good addition to any portfolio, but sector ETFs aren’t a great strategy for growing long-term wealth, because you will yield stable but relative low returns.

Sector ETFs work best when paired in a portfolio with other, longer-range growth investments, such as retirement investment plans, individual index funds, mutual funds, and broader ETFs.

How To Invest in Sector ETFs

You can begin investing in sector ETFs through online and traditional brokerages, such as Vanguard, Fidelity Investments, or Charles Schwab. Some online investment platforms, like Schwab’s TD Ameritrade, also offer sector ETFs.

Key Takeaways

  • Sector ETFs follow the index of a particular industry.
  • Investing in sector ETFs offers you the convenience of trading, combined with diversification options.
  • Sector ETFs work best as a long-term component to an investment portfolio.
  • Mutual funds, broad indexes, and broader ETFs are all good alternatives or complements to sector ETFs.