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First-Quarter Mutual Funds Report

Sector ETFs Allow Investing in Trends

But Strategy Isn't Without Risks

By Meg Richards
Associated Press
Sunday, April 3, 2005; Page F09

With the number of exchange-traded funds rising, more investors are becoming aware of the trading strategies associated with sector ETFs. These baskets of stock can minimize the hazards associated with owning individual equities, allow you to take short positions and make long-term bets. But some experts think sector ETFs are riskier than they appear.

Investors have used actively managed sector funds for many years to target market segments, such as technology and energy, but expenses for such specialty funds have tended to be high. The low cost of indexing, and of ETFs in particular, is part of what makes these newer funds so appealing to institutional and individual investors alike.

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You can collect several sector products for a diversified portfolio, or you can buy just one to play a theme, said Dan Dolan, director of wealth management strategies for Select Sector SPDRS, which divides the nine sectors of the Standard & Poor's 500-stock index into ETFs. For investors who are looking to participate in trends but are disinclined to conduct the sort of deep analysis needed to make smart individual stock purchases, sector ETFs are an easy solution, he said.

"I want to be able to sleep at night, and I want stable growth without having a stock blow up in my face," Dolan said. "The ETF, the sector ETF, gives you more stability. It does everything an individual stock would do, with more diversification. And if I'm right about the concept, it will perform well."

Bad news can easily sink a stock, a point underscored recently when dangers associated with painkillers sent shares of Merck & Co. and Pfizer Inc. on a roller-coaster ride. When even blue chips like these are vulnerable, it makes sense to spread out risk with an ETF, Dolan said, particularly when you're looking to invest in an idea rather than an individual stock.

"If you think the price of oil is going to stay where it is, all of these oil companies will benefit," Dolan said. "If you believe in the aging demographics in this country, and that more money will be spent on health care, being right about an individual stock may not be as important as being right about the concept."

Unlike traditional mutual funds, ETFs are traded intraday, like stocks, so another way investors might use sector ETFs is to sell them short, said George U. "Gus" Sauter, chief investment officer of the Vanguard Group, which offers 10 sector funds among the 23 ETFs in its VIPERs series.

For example, suppose you work for Exxon Mobil Corp. and your company stock makes up an uncomfortably large portion of your portfolio. One way to diversify without selling and paying capital gains is to short the whole energy sector. When you short, you're betting that the security you're investing in will fall. In this case, shorting the sector would serve as a hedge against your large stake in company stock. But like all investments, ETFs are best used as part of a broadly diversified, balanced, long-term strategy, Sauter said.

"We don't think people should place big bets on them," Sauter said. "So many invest by looking in the rearview mirror. We take a more cautious approach. We do believe there are some advantageous uses of sector ETFs. But people who try to move around, chasing after what did well over the last two or three years -- that's a recipe for getting burned."

With so much proliferation of product in the industry, there are now a number of ways to invest in sector ETFs -- through SPDRs, through Vanguard's VIPERs series, which track Morgan Stanley Capital International indexes, and through the iShares series from Barclays Global Investors, which follows Dow Jones indexes, among others.

From the perspective of small investors, the principal difference between these is cost. Vanguard's sector VIPERs are the cheapest, with recently reduced expense ratios of 0.25 percent. The SPDRs are close behind, with an average expense ratio of 0.27 percent, while iShares charges about 0.60 percent, partly to cover marketing costs. But the fees don't tell the whole story, said Dan Culloton, an analyst with fund tracker Morningstar Inc.

"You want to look at the underlying indexes and how well they capture the return of the market segment they're trying to track," Culloton said. "Construction matters, cost matters and management matters. The ability of a manager to track an index, to reduce tracking errors, to manage taxes, all play into the quality of an ETF."

Because all sector ETFs are cap-weighted -- meaning the largest stocks in the basket have the most influence over performance -- they often are closely correlated. But the number of stocks an ETF holds can have an impact on returns, Culloton said. A more diversified fund may be less bumpy than one that's less concentrated; you may get a better yield out of one and no yield at all out of another.

For example, the energy SPDR (XLE) has 28 holdings; the top two, Exxon Mobil and ChevronTexaco Corp., account for more than 35 percent of its weighting, and the top 10 stocks combined make up 66 percent.

By comparison, the energy VIPERs (VDE) has 122 stocks, with 60 percent of its assets in its top 10 holdings, led by Exxon and Chevron.

This illustrates the biggest risk associated with sector ETFs, Culloton said: the danger of being overly concentrated in just a handful of stocks.

"I think sector ETFs are a very dangerous and potentially very expensive toy that most people could do without," Culloton said. "If the average professional money manager can't beat the market, what are the chances of the average individual investor beating the market? The best way to capture gross returns, as much as you can, is to buy a broad-based fund and hang onto it forever. Buy and hold is boring, but it's effective in the long run."


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