About Us
Disclaimer

Sector Investing with Funds


Sector Investing with Funds - animated picture of four investors as plastic figures each taking a sector out of a large pie representing various business industries

Sector

Investing

The basis for sector investing is diversification. This is amongst the first set of general rules that most professional investors would advise beginner investors to follow. Sadly this advice is all too often ignored. Diversifying across the various sectors lowers the overall risk that the investor is exposed too.

Investors often build up their portfolios over a period of time by purchasing stocks that are familiar corporations such as Yahoo or Wal-Mart or they buy stocks that are currently making the financial news headlines. This typically leads to investors owing stocks in only a couple of sectors which increases risk. If the investor's returns are tied to only a couple of sectors and one of those sectors performs poorly then the entire portfolio will produce poor returns. It's a case of not putting all your eggs into one basket. While there are good reasons for buying certain stocks in certain sectors, the issues of risk should always be addressed.

The premise for sector investing is to look at the various sectors and select the stocks accordingly.

Example 1.

As an example, an investor might own an airline stock such as Spirit Airlines, Inc.

A mid-East crisis might send the price of oil soaring which will lower the profits of Spirit Airlines, Inc.

But if the investor also owns an oil stock such as Exxon Mobil Corp. then the risk is balanced as the oil company's profits will increase as the airline company's profits fall.

As a very general rule, the stock prices often move in the same direction for the stocks making up the sector. This because the economic conditions that affect one stock in the sector will often also affect the other stocks in the sector. For example, if the rising oil price affects one airline stock, then the rising oil prices will not only affect the other airline stocks, but also affect other transport companies in general.

Example 2.

As another example, if an increase in labor costs in the manufacturing industry affects Ford, then the increased labor costs will not only affect the other car manufactures but also affect the whole manufacturing industry in general.

Industry Classifications

There are numerous standard industry classifications used within the U.S. stock markets to organize companies into groups which are generally referred to as sectors.

The three main classifications commonly used in financial reporting are ICB, GICS and TRBC. These three are very similar to each other. While there are other classifications, they tend to be more used by economists rather than for financial reporting and market analysis.

Industry Classifications:

  1. The Industry Classification Benchmark (ICB) was developed by Dow Jones & Company, Inc. and the FTSE International group. The ICB classification groups companies into 10 broad groups which the ICB refers to as Industries.
  2. The Global Industry Classification Standard (GICS) was developed by MSCI inc. (Morgan Stanley Capital International) and Standard & Poor's (S&P). The GICS classification groups companies into 10 broad groups which the GICS refers to as Sectors.
  3. The Thomson Reuters Business Classification (TRBC) was developed by Thomson Reuters. The TRBC classification groups companies into 10 broad groups which the TRBC refers to as Economic sectors.

The 10 main sector groups for the ICB, GICS and the TRBC classification systems are shown below in Table 1.

Table 1. ICB, GICS and TRBC sectors

sector investing - table showing the three industry sector ICB, GICS and TRBC classifications

Note that the ICB classification refers to Sectors as Industries.

Sector Balance

Sector investing does not mean that a portfolio needs to be balanced evenly across all ten sectors, but it is a good idea to have exposure to all or at least most of the ten sectors.

Example 3.

For example, in times of economic slowdown, investors may weigh their portfolio more heavily into the Defensive sectors such as Consumer Staples or Utilities.

Companies such as Food Retailers/Producers and Utility companies are less affected in recessions since consumers still require their products as a necessity.

  • Food Retail Companies such as Casey's General Store, Inc. or Ingles Markets, Inc.
  • Food Products companies such as J.M. Smucker Co. or Tyson Foods, Inc.
  • Electricity Utility companies such as Allete, Inc. or Empire District Electric Co.
  • Gas Utility companies such as Southwest Gas Holdings, Inc. or Atmos Energy Corp.
  • Water Utility companies such as American Water Works Co, Inc. or Aqua America inc.

Even in a recession people still need to eat and they still need electricity, gas and water.

The long-term outlook for each sector should be considered but here the view becomes quite hazy. Sometimes the outlook is more obvious over the short-term such as an impeding recession that will see the Consumer Staples and Utility sectors coming into favor. The long-term for some sectors is more obvious such as with the Technology sector where consumers have an appetite for the latest gadgets to make life more enjoyable.

Stocks vs. Funds

A common investing tactic is to buy a sector fund and thus spread their risk across the whole sector rather than with one or two individual stocks. Note that the investor cannot buy a sector; they can only buy a fund that tracks the sector.

The investor can buy individual stocks or they can buy a fund (such as an ETF) over the sector. Each have their advantages and disadvantages and the investor can always buy both stocks and sector funds.

Holding Stocks:

  • The investor can choose the stocks they would like to hold for each sector.
  • There are no ongoing fund management fees.
  • The investor gets the personal satisfaction of being a part owner of the company.

Holding Funds:

  • The sector is truly diversified as funds tend to own a large number of stocks within the sector.
  • The performance of the fund reflects the performance of the sector.
  • Funds charge fees including annual fees which can be quite high (5% or higher). These costs adversely impact on the portfolio's returns.

There are numerous ETF providers and the providers tend to specialize in certain markets. The following three ETF providers: SPDR, iShares and Vanguard - have ETFs available for all the sectors (with the exception of SPDR which does not provide a Telecommunications ETF). These ETF providers are summarized below in Table 1. (table data: Mar 10, 2017)

Table 2. Sector ETF Providers

sector investing - Table showing the Sector ETF Providers for investors to build thier sector fund portfolio

Table data: Mar 10, 2017

There are other ETF providers that cover some of the sectors or have ETFs that broadly cover an industry group but do not fully cover the whole sector.

How many stocks to hold

For the investor who wants to hold stocks, the question is how many stocks should the investor hold in their portfolio.

The opinions do vary but generally between 10 and 20 stocks spread across all or most of the 10 sectors. If the investor only holds 10 stocks this generally means holding only one stock from each sector. Holding less than 10 stocks increases the risk as there are some sectors that the investor has no exposure too.

Sector Investing with Funds - picture of an investment portfolio folder from a sector investor with money shown in the background to signify profitable investments

Holding more than 20 stocks generally increases the amount of work in managing the portfolio and while only slightly reducing the risk any further. Thus it's extra work without really providing any more diversification. However a long-term buy and hold investor could hold more since they generally spend very little time with the ongoing portfolio management.

The advantage of holding 20 rather than 10 stocks is that the investor can skew the weighting of their portfolio in favor of the stronger sectors and thereby potentially increasing their returns while still having a diversified portfolio. For Example, during an economic recession the investor hold more Consumer Staple and Utility stocks and reduce the number of stocks held in the other sectors.

The only way an investor holding 10 stocks can skew their weighting is by reducing or increasing the number of shares owned in each stock. The investor holding 20 stocks can also alter the number of shares owned and they have the advantage of being able to add additional stocks to select sectors.

The GICS Sectors - picture of an animated cartoon investor being surrounded by industry sectors while standing on the world globe

The

GICS

Sectors

The Global Industry Classification Standard (GICS) was developed by MSCI inc. (Morgan Stanley Capital International) and Standard & Poor's (S&P). The GICS classification groups companies into 10 broad groups which the GICS refers to as Sectors. These 10 sectors are discussed below.

1. Energy

The Energy sector comprises companies engaged in the exploration, production and marketing, refining and distribution of oil and gas products. Also included in this section are companies that provide oil rigs and drilling equipment or drilling services.

Companies include Exxon Mobil, BP, Occidental Petroleum and Schlumberge

2. Materials

The Materials sector includes companies that are sensitive to mineral and commodity prices. Companies include chemical and fertilizer companies, industrial gases, aluminum, metals, gold & mining, forest and paper products companies.

Companies include Alcoa, BHP Billiton, Rio Tinto and Dow Chemical Co.

3. Industrials

The Industrials sector consists of companies that manufacture capital goods such as machinery and companies that provide transport such as airlines, railroads and trucking.

Companies include General Electric, Boeing, FedEx and 3M Co.

4. Consumer Discretionary

The Consumer Discretionary sector is made up of the companies whose profits are depended on the spending of the general public. Companies in this sector manufacture and/or sell products such as cars, electronic goods and clothing, they produce newspapers and magazines, and operate hotels, casinos, cinemas, television and radio stations.

Companies include Wal-Mart, Walt Disney, Home Depot and eBay.

5. Consumer Staples

The Consumer Staples sector contains companies that essentially provide the general public the necessities of life. Companies in this sector include food manufacturers and retailers, alcohol, tobacco products, personal and beauty products and non-durable household products such as soaps and detergents.

Companies include McDonald's, Costco and Starbucks Corp.

6. Health Care

The Health Care sector consists of two large groups, Health Care Equipment & Services and Pharmaceuticals & Biotechnology. The health care companies derive their profits from the manufacture of health care equipment or from health care facilities such as hospitals and medical centers.

Companies include Johnson & Johnson, Pfizer, Amgen and UnitedHealth Group.

7. Financials

The Financial sector includes companies such as banks, mortgage finance, insurance, fund managers and asset managers, real estate investment trusts and real estate development.

Companies include American Express, Bank of America and Goldman Sachs.

8. Information Technology

The Information Technology sector includes companies that provide software services, data services, IT consulting, communications equipment, home entertainment systems, computer hardware, electronic manufacturing services and electronic equipment.

Companies include Apple, Microsoft, Google and Intel Corp.

9. Telecommunications Services

The Telecommunication Services sector consists of two broad groups, Diversified Telecommunication Services where the companies use wired services and Wireless Telecommunication Services such as cell phone services.

Companies include Verizon Communications, AT&T and Vodophone group

10. Utilities

The Utilities sector consists of companies that provide Electricity, Gas and Water. The Utilities sector also includes energy traders and alternative power producers.

Companies include NextEra Energy, Exelon and Duke Energy Corp.

Sector ETFs

There are numerous ETF providers and the providers tend to specialize in certain markets. The following three ETF providers: SPDR, iShares and Vanguard - have ETFs available for all the sectors (with the exception of SPDR which does not provide a Telecommunications ETF). These ETF providers are summarized below in Table 1.

Table 1. Sector EFT Providers

the GICS sectors - Table showing Sector EFT Providers for investors to build their fund portfolio

There are other ETF providers that cover some of the sectors or have ETFs that broadly cover an industry group but do not fully cover the whole sector.

An investor could build a portfolio constructed purely of ETFs by buying a sector ETF for each sector. While this is essentially the same as buying an ETF over the S&P 500 index it is not exactly the same. This is due to the difference between the stocks in the S&P 500 index and the stocks in each of the ten sectors.

One advantage of buying all ten sector ETFs over simply buying an S&P 500 ETF is that the investor can easily alter the sector weighting by buying more shares in certain sector ETFs.

ETF Sectors and Industries

Sectors and industries Investing with Funds - picture of three black blocks with large white capital letters that spell ETF for investors to build their fund portfolio

The most common approach to building a portfolio is to buy individual stocks. Modern portfolio theories suggest that the portfolio should be diversified across the 10 broad sectors. For most investors this means holding a minimum of 10 stocks.

While this approach certainly works fine, it can leave investors wondering whether there was an alternative approach. For some investors it can be difficult for them to decide on which stock to pick for each sector.

Sector ETFs

The alternative to picking individual stocks from a sector is to buy an ETF (exchange traded fund) over the sector rather than selecting an individual stock for that sector.

ETFs are bought and sold on the stock market in exactly the same manor as stocks. ETFs have a ticker symbol and have a Bid/Ask spread just like stocks and are traded on an ECN such as ARCA. Also ETFs can generally be bought on margin and sold short.

Investors will typically have numerous candidates to choose from for a particular sector - for example the Healthcare sector. If the investor is finding it difficult to make a decision as to which stock to pick, the investor can simply buy an ETF for the Healthcare sector.

There are several ETF providers that have a Healthcare sector ETF. The investor could buy a SPDR Healthcare Select Sector ETF (symbol XLV) or buy an iShares Healthcare Sector ETF (symbol IYH) or buy a Vanguard Healthcare Sector ETF (symbol VHT).

There are numerous ETF providers and the providers tend to specialize in certain markets. The following three ETF providers: SPDR, iShares and Vanguard - have ETFs available for all the sectors (with the exception of SPDR which does not provide a Telecommunications ETF). These ETF providers are summarized below in Table 1.

Table 1. Sector ETF Providers

sectors and industries - Table showing Sector EFT Providers for investors to build their fund portfolio

There are other ETF providers that cover some of the sectors or have ETFs that broadly cover an industry group but do not fully cover the whole sector.

An investor could build a portfolio constructed purely of ETFs by buying a sector ETF for each sector. While this is essentially the same as buying an ETF over the S&P 500 index it is not exactly the same. This is due to the difference between the stocks in the S&P 500 index and the stocks in each of the ten sectors.

One advantage of buying all ten sector ETFs over simply buying an S&P 500 ETF is that the investor can easily alter the sector weighting by buying more shares in certain sector ETFs.

As an example, an investor might believe that the Technology sector will become a more dominate sector in the coming years as consumers become more technologically savvy. The investor can simply buy more shares of a technology sector ETF. Also the investor does not need to select which individual stocks will perform best.

Industry ETFs

If the investor has a more specific view on an industry, there's a range of ETF providers that have ETFs for specific industries.

Example 1.

Let's suppose that an investor has a view that the insurance industry will perform strongly over the next few years. The investor could buy a Financial sector ETF which covers the insurance industry, but this includes a wide range of industries that the investor does not have a view on.

The investor could be more specific and buy an industry ETF rather than the broader sector ETF. The investor could buy an Insurance Industry ETF such as an iShare Insurance ETF (IAK) or a SPDR S&P Insurance ETF (KIE).

Example 2.

As another example, an investor has a short list of five Pharmaceuticals stocks that the investor feels could perform strongly.

Rather than trying to decide which stock to include in their portfolio, the investor could simply buy an ETF over the Pharmaceuticals Industry - such as iShares US Pharmaceuticals ETF (IHE) or PowerShares Pharmaceuticals ETF (PJP).

A selected list of common Industry ETFs is provided Table 2. below (Table data: Mar 10, 2017)..

Table 2. Selection of Industry ETF's

sectors and industries - Table showing industry EFT Providers so that investors can build their fund portfolio

Table data: Mar 10, 2017

An advantage with industry ETFs over stocks is that an industry ETF spreads the risk across the entire industry rather than containing it within one stock from that industry.

The disadvantage is that there is an ongoing annual management fee. The fee is also known as the Annual Operating Expense which is generally under 0.5% per year and some ETFs are under 0.2%. While this is an ongoing fee it's relatively low and is normally deducted from the dividends the fund receives. Therefore there's normally no out of pocket expenses.

Industry and sector ETFs provide the investor with alternatives to buying the stock. At times this may suit the investor's needs and if it does not then at least the investor is aware that there are alternatives to buying individual stocks.

Blog Articles