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I want to invest in sector ETFs. How do I choose between the different options in a given sector? Thanks, Z.V.
The rapid proliferation of new ETFs can be viewed as a good development, as it gives investors more options to choose from.
But it can also make deciding between similar products very challenging. For instance, Morningstar.com lists 24 ETFs that represent some slice of the technology market, 22 natural-resources ETFs, 15 financials ... you get the picture.
There are a lot of products out there, and they're not all created equal.
Before buying an ETF, there are several things to consider, but two of the biggest questions you should ask are what exactly am I buying, and how much am I paying for it.
Consider the first point: While several ETFs may represent the same sector, the indices that they track can vary greatly in terms of which companies are included, number of holdings (which can affect volatility), how the securities are weighted and how long the index has been around (some people aren't comfortable relying on back-tested data).
To better illustrate this point, take a look at some of the financial-sector ETFs.
One option is the
Financial Select Sector SPDR
. This ETF tracks the financial stocks that are included in the market-cap-weighted
The resulting portfolio includes 87 of the largest U.S. financial stocks. While 87 holdings is nothing to scoff at, that's a lower number than many of its peers. It is also particularly concentrated, with about 50% of its assets in the top 10 holdings.
Another choice is the Vanguard
. This fund tracks the financial stocks in the MSCI U.S. Investable Market 2500 Index.
VFH is more diversified than XLF, with a whopping 548 financial stocks included. And unlike XLF, it allocates assets toward micro-, small- and mid-cap stocks, and that diversification can make it less volatile. It is also a bit less concentrated, with roughly 38% of its assets in the top 10 holdings.
Another product with a slightly different spin is the
iShares S&P Global Financials Sector Index Fund
, which tracks the S&P Global Financials Sector Index, a subset of the S&P Global 1200 Index.
This ETF follows about 230 stocks, but unlike other financial-sector ETFs, it has a global focus, with almost 60% of its portfolio made up of foreign holdings.
This adds an additional level of diversification to the ETF, which could also decrease volatility. In addition, this fund is less concentrated than both XLF and VFH, with only a quarter of its assets contained in the top 10 holdings.
Several other ETFs are classified as financial-sector products as well, including (but not limited to) the recently launched PowerShares
FTSE RAFI Financials Sector Portfolio
iShares Dow Jones U.S. Financial Sector
streetTRACKS KBW Capital Markets
Costs, of course, are another important factor to consider.
ETFs that track domestic, market-cap-weighted indices tend to have similar expense ratios. But when you start tracking indices that include international stocks, less-liquid stocks or use different methodologies to select and weight stocks, you're likely to see higher expense ratios.
You may be willing to pay more for an ETF if you believe it will make up for the costs in performance, but once again, you have to really do your homework to make sure you know what you're getting.
Looking at the financial sector again, XLF and VFH are both based on market-cap-weighted indices that primarily track domestic financial stocks. And their expenses are very similar -- 0.24% for XLF and 0.26% for VFH. However, IXG, because it includes a high percentage of international stocks, charges 0.48%.
And some products carry even higher expenses. For instance, the PowerShares FTSE RAFI Financials Sector Portfolio tracks an index that weights financial stocks based on fundamental measures such as sales, cash flow, book value and dividends. Because of this more complex weighting methodology, the fund charges up to 0.60%.
In addition to expense ratios, you should also look at bid-ask spreads (which could be affected by liquidity), because they can add to your costs.
There are many Web sites, such as
Morningstar.com, that provide information and tools that can help you compare different products. But if you can't find what you're looking for there, check out the ETF companies' Web sites, where you should be able to locate the necessary information.