Exchange-traded funds (ETFs) are investment vehicles that mirror the movement of a basket of stocks or an underlying index. Sector-specific ETFs, or sector ETFs, operate on the same principles but with a focus on a particular sector. Thus, sector ETFs might be considered by investors who seek to capitalise on emerging trends in particular segments of the economy such as technology, infrastructure, healthcare etc.
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What is sector ETF?
Sector exchange-traded funds (sector ETFs) are funds that invest in a bouquet of stocks from a particular industry or sector (like technology, healthcare, or energy). They offer investors broad exposure to a chosen sector without them having to pick and choose individual stocks.
Thus, sector ETFs aim to replicate the performance of a sectoral index, such as Nifty Bank, Nifty Pharma, or Nifty IT. Simply put, they are a diversified group of stocks of companies from a particular industry.
How do sector ETFs work?
Sector ETFs function like any other exchange-traded fund but with a focus on a specific sector. They are listed on stock exchanges and can be bought or sold during trading hours, thus offering higher liquidity compared to other mutual funds.
A sector ETF is typically constructed by selecting and buying the same stocks that comprise its benchmark index. For example, to track the banking sector, an ETF may consider Nifty Bank as the benchmark and buy the stocks it includes in the same weights as they are in the index.
The price of the ETF reflects the overall movement of the stocks of the sector it tracks. ETF returns are generated through capital gains, and dividends, from the underlying stocks.
Read Also: What Are Index ETFs? Benefits, Types & How They Work
Key features of sector ETFs
- Targeted exposure: Offers investors the opportunity to tap into the potential of a growing sector by mirroring major stocks from that industry.
- Low cost: Sector ETFs have expense ratios that are typically lower than actively managed funds making them attractive for investors.
- Liquidity: These funds are traded throughout market hours like a stock and are highly liquid.
- Transparency: Holdings are publicly available and mirror the index for the investors to review their exposure.
- Diversification: Sector ETFs invest across a variety of stocks from a sector which protects against being overexposed to a single stock.
What are the pros and cons of sector ETFs?
The pros of sector ETFs are as follows:
- Sector focus - These funds are focused on specific sectors and investors can choose one they believe has good growth prospects.
- Diversification within the sector: The burden of stock picking and diversification does not rest on the investor, as sector ETFs buy stocks of multiple companies that accurately capture the overall performance of a sector.
- Ease of access – These ETFs offer a convenient way for investors to invest in industry trends without committing a lot of personal capital.
- Lower expenses - These funds are usually passively managed and have lower expense ratios than most actively managed funds.
The cons are as follows:
- Concentration risk– Highly focused sector funds could lead to volatility if the sector underperforms or goes through turmoil.
- Tempered returns– Sector ETFs cannot beat market indices as they track the underlying stocks, hence these funds may not generate alpha (i.e., returns that beat the market).
Read Also: Global ETFs: Meaning, Benefits and How to Invest?
What are other key considerations while choosing a sector ETF?
Before investing, you must evaluate the following:
- Sector outlook: If the sector in consideration is poised for long-term growth over major sectors, then it can be a good bet, else it may be worth looking at other sectors that offer better returns.
- AUMs and liquidity: Picking ETFs with higher trading volumes and AUMs (fund size) will ensure liquidity should the need for it arise.
- Tracking: It is wise to understand the index that is tracked by the ETF, its methodology, and past returns to ascertain how accurately the performance of the sector is captured.
- Expense ratio: Since these funds are passively managed, the fees are lower than those of actively managed funds.
- Underlying holdings: The underlying stocks of the ETF must be reviewed to spot any red flags that could potentially drag the overall returns downwards.
Who should invest in sector ETFs?
Sector ETFs are suited for long-term investors seeking affordable, and diversified access to the growth of an industry they deem to be attractive. These funds are a good instrument for investors with the knowledge and skills to evaluate a sector but may not be as appropriate for beginners, who may benefit more from broader diversification.
How to invest in Sector ETF?
Investing in sector ETFs is seamless, like buying a stock. Both, SIPs (with some ETF platforms) and lump-sum investments can be used to invest:
- Identify a sector based on research or market outlook.
- Choose a listed ETF that tracks the sector’s index with a reasonable expense ratio, and review past returns.
- Open a demat and trading account with a registered broker if you don’t already have one.
- Place a buy order on the stock exchange, just like buying a stock during market hours.
- Monitor the performance and review the industry, and the holdings of the selected ETF.
Conclusion
Sector ETFs offer a balance by providing diversified access to a specific industry tipped to take off in the near future. They operate by tracking an underlying index and offer a cost-effective, liquid and transparent investment option for intermediate investors to allocate capital to a sector of choice. With the right level of confidence, research and monitoring, sector ETFs can be a key component in the journey to build long term wealth.
FAQs:
What is a sector ETF, and how does it work?
A sector ETF, meaning a sector-specific fund, invests in stocks of companies in a particular industry. It tracks a sectoral index and offers diversified exposure to the sector with a single investment.
How do I choose a suitable sector ETF to invest in?
Consider the sector’s growth prospects, the ETF’s AUM, expense ratio, and tracking error to choose an ETF tailored to your investment goals
Are sector ETFs suitable for long-term investors?
Yes, they offer access to the long-term growth and returns of a sector but require higher conviction and periodic review.
What are the risks associated with sector ETFs?
Sector ETFs are less diversified and can be volatile. They are exposed to sector-specific issues like regulatory changes or economic downturns that can affect returns.
Can sector ETFs be used for portfolio diversification?
Yes, but only within a sector. To diversify across the market, combine sector ETFs with broad market funds or index funds.
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