Introduction
Sector ETFs allow investors to focus on a specific part of the economy without selecting individual companies. A technology ETF, for example, can hold a portfolio of technology companies, while a healthcare ETF may own pharmaceutical, biotechnology, medical equipment, and healthcare service businesses.
This targeted exposure can be useful, but it also means sector ETFs are generally less diversified than broad-market funds. Their performance can depend heavily on economic conditions and trends affecting one industry group.
What is a sector ETF?
A sector ETF is an exchange-traded fund that invests primarily in companies belonging to a particular economic sector. Many sector ETFs track indexes, although actively managed sector funds also exist.
Rather than buying several individual companies within an industry, an investor can use one ETF to gain exposure to a basket of related businesses.
Sector classifications vary by index provider, but common categories include information technology, healthcare, financials, consumer discretionary, consumer staples, industrials, energy, materials, utilities, real estate, and communication services.
How sector ETFs work
A sector ETF follows a defined investment mandate. If it tracks an index, the fund generally holds securities according to the index’s inclusion and weighting rules.
Some indexes weight companies by market capitalization, which means the largest companies can represent a significant percentage of the ETF. Other sector strategies may use equal weighting or additional selection criteria.
As a result, two ETFs covering the same sector can have different holdings, concentration levels, and performance.
Common sectors
Technology
Companies involved in software, semiconductors, hardware, IT services, and related technologies.
Healthcare
Businesses such as pharmaceutical companies, biotechnology firms, healthcare providers, and medical equipment manufacturers.
Financials
Banks, insurers, capital-market firms, and other companies providing financial services.
Energy
Companies involved in oil, natural gas, energy equipment, and related activities.
Consumer sectors
Consumer discretionary covers more economically sensitive spending, while consumer staples includes many everyday necessities.
Utilities
Companies providing electricity, gas, water, and other regulated or essential utility services.
Why investors use sector ETFs
Sector ETFs can be used to increase exposure to an area of the economy an investor expects to perform differently from the broader market. They can also help adjust an existing portfolio’s sector allocation without buying individual stocks.
Another use is diversification within a particular industry. An investor interested in healthcare, for example, can spread exposure across multiple healthcare companies rather than relying on the success of one business.
However, diversification within one sector is not the same as diversification across the entire economy.
Risks of sector ETFs
The main risk is concentration. A broad-market fund can hold companies across many industries, while a sector ETF is deliberately exposed to a narrower part of the economy.
Regulatory changes, commodity prices, interest rates, technological disruption, or shifts in consumer demand can affect some sectors much more than others.
Individual holdings can also create concentration risk. In a market-cap-weighted sector ETF, a small number of very large companies may account for a substantial portion of the portfolio.
Sector ETFs vs broad-market ETFs
| Feature | Sector ETF | Broad-market ETF |
|---|---|---|
| Exposure | One sector or industry group | Multiple sectors |
| Diversification | More concentrated | Generally broader |
| Sector-specific risk | Higher | Spread across more areas of the economy |
| Use | Targeted exposure or portfolio adjustment | Core market exposure |
| Performance drivers | Heavily influenced by one sector | Influenced by the wider market |
What to compare between sector ETFs
Investors should examine the fund’s sector definition, underlying index, largest holdings, weighting method, number of holdings, expense ratio, and liquidity.
It is especially useful to check how much of the ETF is concentrated in its top holdings. A fund containing dozens of companies can still be highly dependent on a handful of large stocks.
Sector ETFs provide targeted exposure, but that precision comes with greater concentration. They should therefore be evaluated differently from broad-market funds designed to represent much larger portions of the economy.
Key takeaways
- Sector ETFs invest primarily in companies from a specific part of the economy.
- They provide targeted exposure without requiring investors to select individual companies.
- Sector ETFs are generally more concentrated than broad-market ETFs.
- Funds covering the same sector can differ because of their indexes, weighting methods, and holdings.
- A small number of large companies can dominate a market-cap-weighted sector ETF.
- Sector definition, concentration, costs, liquidity, and largest holdings are important factors to review.