Sector ETFs: capture "smart beta" with targeted exposure

The sharemarket typically follows the cyclical nature of the economy, experiencing periods of growth and periods of decline.

While investing in the market as a whole may provide an average return, investing in specific areas of the market that stand out, such as the thriving tech sector over the past decade, can potentially deliver higher long-term capital growth for investors who can withstand higher short-term volatility.

For investors who try to profit from the business cycle or seek to outperform the market, selecting a promising sector or industry is crucial. A convenient and diversified approach to gaining exposure to a specific market sector is through sector ETFs, which eliminate the need for individual stock selection and reduce investment risks.

In this article, we’ll examine how sector ETFs can potentially enhance investment returns for investors.

What are sector ETFs?

Sector ETFs are investment funds that track the performance of stocks within a specific sector or industry.

Essentially, a sector refers to a group of companies that provide similar products or services in the market. By investing in a sector ETF, investors can obtain exposure to a broad range of companies within that sector, rather than investing in a single stock.

For instance, a sector ETF in Australia that focuses on the resources sector would invest in a diversified portfolio of resources companies, such as BHP Group Ltd (BHP), Rio Tinto Ltd (RIO) and Woodside Energy Group Ltd (WDS). Similarly, a sector ETF concentrating on the financial industry would invest in banking companies like the ‘Big Four’ banks.

To categorise companies based on their key business activities, the Australian Securities Exchange (ASX) and many global index providers use the Global Industry Classification Standard (GICS), which enables market participants to identify and analyse companies at four levels of granularity using a common global standard, including 11 sectors, 25 industry groups, 74 industries and 163 sub-industries.

Sector ETFs available on the ASX

Sector ETFs traded on the ASX can be classified into two categories: domestic and global.

Domestic sector ETFs track the performance of Australia’s major industries, such as resources and financials. As of April 2024, the ASX has eight domestic sector ETFs available, focusing primarily on resources, financials and technology.

On the other hand, global sector ETFs provide investors with a broader range of choices, covering various industries worldwide, such as battery technology, cybersecurity and robotics. As of April 2024, the ASX offers 40 global sector ETFs. The table below displays the top 10 global sector ETFs ranked by assets under management (AUM).

As shown, returns on global sector ETFs can significantly vary. For instance, while both RBTZ and ROBO concentrate on robotics, the former recorded a 1-year total return of 23.44%, significantly higher than the latter’s 5.52%. This difference arises because the two ETFs track different benchmark indices, leading to varied constituents and performances.

Therefore, when investing in a sector ETF, it’s essential to understand the benchmark index it tracks and its constituents. Typically, sector ETFs that have a higher concentration of particular constituent stocks tend to be more volatile compared to those with less concentration.

Sector ETFs available in the US

There are over 800 sector ETFs available in the US, totaling assets under management (AUM) of approximately US$1 trillion. Some sector ETFs focus on specific sub-sectors within a broader industry, while others offer exposure to multiple industries within a particular sector.

The table below shows the top 10 sector ETFs by AUM, with the tech sector playing a big part.

To discover additional US sector ETFs on moomoo, simply navigate to Markets > US > ETFs > Heat Map > Sector.

Things to consider before investing in sector ETFs

There is no such thing as the forever-best sector, and investors should be aware of this. When it comes to investing in sector ETFs, it’s worth considering the following factors:

• What’s the top performing sectors?

Given its status as the world’s largest sharemarket, the performance of the US sharemarket can provide valuable insights for investors seeking to identify suitable sectors for investment.

The performance of the S&P 500 sectors over the past decade reveals that information technology has been the top-performing sector, followed by consumer discretionary, healthcare, financials, and industrials.

Investors often categorise stocks into two broad categories: cyclical and defensive sectors. These classifications are based on the sensitivity of a particular industry to the overall economic cycle.

Cyclical sectors are those that are most sensitive to the ups and downs of the economy. These include communication services, consumer discretionary, financials, real estate, industrials, technology and materials. ETFs in these sectors are more vulnerable during economic downturns but tend to perform well during periods of growth.

On the other hand, defensive sectors are those that are less sensitive to economic cycles. Companies in these sectors typically provide essential goods and services that people need regardless of the state of the economy. Defensive sectors include consumer staples, healthcare, energy and utilities. These sectors tend to perform better during economic downturns but may underperform during periods of growth.

Sector ETFs can serve as efficient tools for sector rotation because of their liquidity, diversification and sector exposure. Sector rotation is an investment strategy that involves holding an overweight position in strong sectors while maintaining underweight positions in weaker ones. For example, technology stocks are usually popular in an economic expansion.

• Take a closer look at ETF labels

It’s essential to bear in mind that ETF labels can be misleading, and sector ETFs can differ significantly from one another, even if they have similar names.

For example, let’s take a look at two of the largest semiconductor-related ETFs, the VanEck Semiconductor ETF (SMH) and the iShares Semiconductor ETF (SOXX). While both ETFs focus on the semiconductor industry, they track different indices and employ different weighting methodologies.

The SMH tracks the MVIS US Listed Semiconductor 25 index, which is a market-cap-weighted index of the largest US-listed semiconductor companies. As of April 2024, Nvidia Corp (NVDA), the world’s largest semiconductor company by market cap, accounts for over 20% of the SMH’s net assets.

In contrast, the SOXX tracks the PHLX Semiconductor Sector Index, which employs a capping methodology on market-cap-weighting. The top five securities’ weights are capped at 8%, while the remaining securities are capped at 4%. As of March 2024, Nvidia Corp accounts for just over 8% of the SOXX’s net assets.

These two examples illustrate how different ETFs can be, even within the same sector. This could result in quite different performance and volatility of the portfolios. Therefore, it’s crucial for investors to conduct thorough research and analysis before investing in sector ETFs to align with investment goals and risk tolerance.

• Identify sectors with strong momentum

Investors seeking to potentially boost returns and decrease volatility relative to a simple buy-and-hold approach may consider investing in sector ETFs with strong momentum.

One way to gauge momentum is by examining returns over a period of time. On moomoo, investors can easily filter the returns of US sector ETFs over various periods, such as 60 days, 120 days or year-to-date.

A straightforward sector rotation strategy involves investing in several sectors with the strongest performance over a specific period, such as 60 days. Each month, investors would evaluate the 60-day returns of the 11 sectors, selling those that fall out of the top performers and reinvesting that money in the sector that replaced it.

Bottom line

Sector ETFs provide a straightforward means for investors to gain exposure to specific areas of the market. Whether seeking to outperform the broader market or capitalise on the business cycle, sector ETFs enable investors to easily construct diversified portfolios.

Sector rotation is an investment strategy that empowers investors to capitalise on market trends and potentially enhance investment outcomes. By strategically shifting allocations towards sectors anticipated to perform well and away from those expected to underperform, investors can potentially achieve higher returns and reduce volatility.