When Sector ETFs Are a Bad Bet

The rise of exchange-traded funds has made it easy for investors to spice up their portfolios with a variety of investments from different sectors. But this convenience comes at a big price. By removing the element of stock picking from investing in a particular area of the market, ETF investors lose a vital advantage that individual shareholders can capitalize on.

Playing it safe
For many investors, ETFs draw the perfect balance between the potential rewards of making smart stock picks versus the risks of buying shares of particular companies. When you buy a sector ETF, you want things to go well for the industry as a whole. You don't have to worry so much about company-specific problems that can destroy a stock.

Yet the biggest advantage of ETFs is also their biggest weakness. By playing it safe and essentially splitting up your money across lots of industry players, you lose the ability to take advantage of competitive pressures that favor one company over another.

Let's take a look at a few examples of this phenomenon within several different industries.

1. Energy
With energy prices having been all over the map in the past three years, energy stocks face unique challenges right now. While oil prices have recovered much of the ground they lost when the commodities boom ended in late 2008, natural gas prices are still languishing. That disparity creates a dynamic within the energy industry that many investors find interesting.

If you buy a typical energy ETF, you'll probably end up with a bunch of shares of both ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) . Yet the two companies are taking much different views of the energy industry going forward. ExxonMobil has made a big bet on a recovery in natural gas by buying XTO Energy. Meanwhile, Chevron has 69% of its reserves in oil rather than gas, and it reduced its refining business at an opportune time.

2. Technology
More than any other sector, tech stocks run the gamut from behemoth slow-growth stalwarts to fast-growing innovators. Yet most tech ETFs end up owning both ends of the spectrum and therefore don't maximize the benefits of either one.

The best examples of this phenomenon are Apple (Nasdaq: AAPL  ) and Microsoft (Nasdaq: MSFT  ) . Never did two competitors more clearly draw battle lines against each other, and the two companies are light-years apart in terms of their current prospects. Apple is at the top of its game, riding a long series of successful products. Meanwhile, Microsoft has coasted along on past successes, reaping huge cash flow from its core Windows operating system and Office suite but suffering several failures in competitive offerings ranging from its Zune media player to its Kin smartphone.

Both companies have appealing attributes to investors. But if you strongly believe in the prospects for one of them, you probably aren't excited about owning shares of the other. Most ETFs force you to own both.

3. Retail
For every demographic, you'll find a retailer catering to it. By owning shares of lots of retailers, sector ETFs largely punt on the question of which segment of the population is most profitable -- and that takes an important consideration off the table.

For instance, there's always a question about whether Wal-Mart's (NYSE: WMT  ) target customer can produce bigger profits than Tiffany (NYSE: TIF  ) and other high-end retailers. On one hand, luxury items are more discretionary purchases than the necessities you'll find at retailers like Wal-Mart. But if rich consumers recover more quickly from the recession, then Tiffany could see much stronger sales gains, further underpinning its status as an up-and-coming dividend stock.

Similarly, age considerations come into play. Chico's FAS (NYSE: CHS  ) favors an older demographic, while teen-targeted retailer Aeropostale depends on spending from younger customers. Who has more discretionary spending money can make a big difference to their respective results.

A savvy investor can draw distinctions among these groups and make strategic investments in particular companies. Sector ETF shareholders, on the other hand, are largely stuck with a mix of all of them.

The cost of diversification
As a cheap way to build a diversified portfolio, ETFs are excellent choices. But they have drawbacks if you want to take a stand on particular companies. If you have that additional insight, then investing in individual stocks will give you much more of what you're looking for.

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True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger mixes individual stocks with betting the field. He owns shares of Apple. Microsoft and Wal-Mart are Motley Fool Inside Value recommendations. Apple is a Motley Fool Stock Advisor selection. Chevron is a Motley Fool Income Investor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Aeropostale, Apple, ExxonMobil, Microsoft, and Wal-Mart. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy can do anything it sets its mind to.


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