We recently discussed investing in broad indexes to diversify a portfolio, but when investors would like to focus on a specific sector or sub-sector within the broad market, they often look for individual stocks that participate in a desired sector. As noted in the 2000-2002 bear market, investing in individual stocks can have excessive company specific risk ? think Enron. Our approach would be to buy the entire sector or sub-sector through the use of specialized Exchange Traded Funds (ETF). While these funds don't protect against market downturns, they do spread the risk out amongst many companies. The result is desired exposure to a particular area of the economy without the need to place a bet on individual stocks.
Let's take a look at a sector that has been in the news lately ? oil. In the past, an investor had to research dozens of companies trying to guess which one would be the best stock to invest their money. Now you can buy an ETF, for example, the Select Sector Energy ETF (XLE), which includes around thirty different oil stocks. This can be purchased at any time during market hours, and more importantly, it can also be sold at any time. If you?re feeling bearish on oil, you can short this fund as well.
It is important for investors to understand what they are buying, even with ETFs. For example, there are currently 11 different ETFs that focus on energy and commodities.
So how does one choose the ETF that meets their individual needs? First, review the prospectus to determine the overall goal of the fund, which sector or sub-sector are they are tracking, and what holdings make up that sector. Market capitalization ETFs have more exposure to large companies. Recently, ETFs that have equal or near equal weighting within their portfolios. Currently, an investor can choose a few Energy sector ETFs and sub-sector ETFs in oil exploration, clean energy, and oil services. Second, find out if or when the index is recalibrated to add or remove companies from the mix. Fundamental and/or technical recalibration on a quarterly basis is found with some of the newer ETFs.
Investing in specific sectors can involve additional risk than investing in a broad index, so it's important for investors to do their homework or hire a professional to help them. After all, when it comes to investing, buying is frequently the easy part. Knowing when to sell will determine your success or failure.