Sector investing with exchange traded funds

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Not long ago, sector investing was the province of institutional investors, who moved in and out of stocks in different industries to take advantage of cyclical changes in business activity. Today, this "sector rotation" strategy is also accessible to individual investors. Thanks to sector funds, and most recently, sector-based exchange-traded funds (ETFs), individuals can easily invest in a cross-section of companies representing a particular sector or industry. But before investing in a sector ETF, take a minute to acquaint yourself with concepts underlying sector investing, its risks, and the cost considerations involved with ETFs.

What is sector investing?

Simply put, sector investing is a top-down investment strategy that involves identifying specific economic sectors and subsectors that are expected to outperform, and investing in strong companies within them. It's a way of capitalizing on market shifts caused by changing business conditions and investor focus.
Fundamental to sector investing is the fact that different sectors and industries perform differently in different phases of the business cycle. Typically, growth sectors, such as information technology, do best during an expansion, while defensive sectors, such as food products and tobacco, fare better during a contraction. At any given time, some sectors will perform better than others, creating opportunities for investors.
Sectors are also impacted differently by trends or specific events. Rising interest rates, for example, may have a negative impact on the financial services sector, but very little effect on the health care sector. Consumer discretionary industries such as construction, automobiles, or household durables tend to be particularly sensitive to business cycles, while consumer staples and other "defensive" sectors tend to be better insulated from changes in economic activity.
Essential to sector investing is the need to define sectors and industries on a consistent basis, so that all companies can be classified within a framework that accurately reflects their business. Any classification standard must also be flexible enough to adapt easily to a constantly changing investment world. To meet these needs, Standard & Poor's, together with Morgan Stanley Capital International, developed the Global International Classification Standard, or "GICS." Under the GICS structure, companies are classified in one of 163 sub-industries, which are grouped into 74 industries, 25 industry groups, and 11 sectors. This four-tier structure accommodates companies across the world and dramatically facilitates sector analysis and investing.

Why ETFs?

The ideal way to invest in a sector may be to hold a diversified mix of stocks considered representative of that sector. For most investors, the easiest way to do this is to buy shares of a sector mutual fund or ETF. Sector mutual funds come in many different varieties, some actively managed and others designed to parallel a particular sector benchmark — so-called index funds. ETFs go a step further, offering the low fees of index funds and the agility of stocks.
Here's how ETFs work. An institutional investor deposits a specified block of securities in a fund. This "basket" of stocks reflects the composition of an index, such as the S&P 500 or the Nasdaq 100. Shares of the fund are then listed on an exchange. Unlike mutual funds that must be purchased or sold at their end-of-day NAV, ETFs can be bought and sold in real time at prices that change throughout the day. ETFs can thus be used for certain hedging strategies typically associated with stocks, such as buying on margin and selling short.

Costs are key

Like any other investment, there are costs associated with ETFs. Brokerage commissions are paid on a per-trade basis to buy or sell shares just as they are with stocks. ETFs also have management expenses. However, they may be lower than traditional actively managed mutual funds. Also remember that commissions apply to ETF purchases, so ETFs may be inappropriate for a regular investment plan such as dollar cost averaging.

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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

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Diversification does not ensure a profit or guarantee against loss.

Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that shares, when redeemed or sold, may be worth more or less than their original cost.

Like other financial products, ETFs also have certain disadvantages, including the following:

  • ETFs generate brokerage commissions on every trade, so frequent rebalancing and dividend reinvestment can potentially erode their cost benefits.
  • There can be a difference in the value of an ETF and its corresponding index. ETFs trade on an exchange and, as a result, may trade at a premium or discount to the value of the portfolio's underlying holdings.
  • ETFs don't always fully match the performance return of their corresponding index because they have underlying management expenses. In addition, it is difficult for international and fixed-income ETFs to fully replicate their benchmarks.
Please note that ETFs are registered investment companies that have prospectuses containing detailed information about the fund, including expenses and risks. Some ETFs may also have product descriptions, which summarize key information about the ETF and explain how to obtain a prospectus. You should carefully consider the investment objectives, risks, charges, and expenses before investing in this product. This and other important information is included in the prospectus, which should be read carefully before investing.

All asset classes are not in the best interest of all investors. Each investor should select the asset classes for them based on their goals, time horizon, liquidity needs, and risk tolerance.

Investments focused in a certain industry may pose additional risks due to lack of diversification, industry volatility, economic turmoil, susceptibility to economic, political or regulatory risks and other sector concentration risks.