By Dan Caplinger | September 19, 2012
The Motley Fool has helped ordinary people become better investors for nearly two decades. This month, we're reaching out to millions of investors to help guide them in their quest toward financial knowledge and independence.
Along those lines, I'm planning to take a look at different exchange-traded funds available to investors today. ETFs have skyrocketed in popularity, but it's important to understand exactly what you're getting when you buy an ETF. Today, I'd like to take a broad look at sector ETFs, which let you drill down on a particular part of the market.
Exchange-traded funds have become one of the most useful tools investors have. By giving you a diversified investment in a single package, which you can nevertheless buy and sell at will whenever the market is open, ETFs offer a lot of flexibility.
Initially, many of the first ETFs available to investors tracked extremely broad segments of the market, such as the S&P 500. That was great for those who subscribed fully to the passive investing philosophy, which recommends simply trying to match the market's performance, rather than beating it.
But many investors believed that they could outperform the indexes by choosing stocks from more promising industries while avoiding less successful ones. At the same time, they didn't want to guess which company would prevail over its competitors; they just believed that an industry in general would outpace the broader market.
In late 1998, the SPDR family of ETFs came out with sector ETFs based on the industries in the S&P 500. With nine different ETFs making up its Select Sector SPDR group of ETFs, investors could own shares of all the S&P 500 stocks that fell into a particular industry. And with annual expenses of just $18 per $10,000 invested, that diversification came at a reasonable cost. Since then, a host of other sector-specific ETFs have come out, competing with the SPDRs and using different strategies to pick stocks.
Although Select Sector SPDRs are useful in giving you exposure to dozens of stocks, their market-cap weighting sometimes creates unexpected concentration. For instance, in the Energy Select Sector SPDR, more than a third of your money will go toward just two stocks: ExxonMobil (NYSE - XOM) and Chevron (NYSE - CVX). Those integrated oil giants play a big role in the industry, and their fortunes are largely tied to those of their peers. But if you're hoping to score big on a new oil discovery, you'll want to try to pick individual stocks to add to a core ETF holding.
You can find similar concentrations in other sector ETFs. Apple (Nasdaq - AAPL) by itself makes up 21% of the technology sector ETF, while the top four stocks in the consumer staples SPDR, which include Philip Morris International (NYSE - PM) and Procter & Gamble (NYSE - PG), add up to 45% of its total assets.
Again, those concentrations may be perfectly acceptable for you. Apple has certainly rewarded those bold enough to allow the hot technology stock to keep its highly weighted position in their portfolios, with shares having punched above $700 yesterday on solid iPhone sales. Meanwhile, consumer stocks like Philip Morris and P&G provide much-needed ballast for conservative investors, and Philip Morris in particular has been a lucrative way to invest in tobacco while avoiding many of the regulatory problems of U.S.-based tobacco companies.
But the key to sector ETFs is to know the exact mix of concentration and diversification you're getting. If you don't know about it, you can't prepare for it, and that's important if you're looking to sector ETFs to help you get a broad spectrum of different stocks in a particular industry. Moreover, because there are so many different flavors of sector ETFs out there, becoming familiar with each one's particular quirks can help you pick the one that exemplifies the attributes you're looking for.
To find out more about one set of sector ETFs, take a look at the home page for the Select Sector SPDRs.
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