US Industry

Domestic industrial sector ETFs can be quite powerful tools as investors underweighting financials and overweighting energy have shown in recent years. Three broad lines are suitable for most investors and are the subject of this report. The SPDR Select Sector line stops at large cap companies from the S&P 500, while iShares' Dow Jones US line and Vanguard's line includes companies of every size.

The above graph shows how much better investors fared by selecting the right industries to overweight. (These returns are taken from iShares' Dow Jones line.) Not every year shows such diverging fortunes, of course, and there is always the chance that one may pick the wrong industry. Still, the tool is undeniably powerful.

SPDR has a comprehensive line of sector ETFs with its 10 Select Sector funds covering major industries. Bought in the right proportions, SPDR Select Sector ETFs together are equivalent to an S&P 500 ETF. This line is therefore ideal for the many S&P 500 investors who wish to cleanly overweight one or more sub-indexes of the S&P 500. They can start with a core holding of SPY and then round out with one or more Select Sector ETFs as satelite holdings. A more sophisticated industry slice and dice is also possible. Or investors can ignore SPY and instead buy representative amounts of all Select Sector ETFs, over- and underweighting where desired. This allows true fine tuning of exposure to each industry of the S&P 500 as economic cycles unfold.

The SPDR line contains large cap companies only and represents about 75% to 80% of the US market. Following such a popular index makes it easy for investors to track because its changes are reported so widely. But it also suffers slightly from turnover inefficiency during additions of growing mid-cap companies and demotions of large cap companies to mid-cap indexes. Annual fees of .23% are quite competitive.

iShares uses Dow Jones U.S. Index to create 10 major sector lines. It's a total market approach which targets about 95% of the investable US market. So each sector iShares DJ fund has plenty of mid- and small-cap and represents economic activity of each industry fairly well. For most long-term investors, this approach is best. Additions from or demotions to micro-cap status are insignificant, so it is relatively efficient in terms of turnover. And mid- and small-cap companies bring additional diversification.

iShares' DJ line investors should not confuse major sector ETFs with their subsector ETF offspring. For instance, iShares Dow Jones U.S. Energy (NYSEArca:IYE) is composed of iShares Dow Jones US Oil & Gas Exploration & Production (NYSEArca:IEO) and iShares Dow Jones US Oil Equipment & Services (NYSEArca:IEZ). It only makes sense to either buy IYE if a basic energy allocation is desired or IEO and IEZ if fine tuning of exposure to exploration or operations is desired. Financials are a bit of a maze. The main sector fund iShares Dow Jones US Financial Sector ETF (NYSEArca:IYF) is composed of banking, insurance, real estate (!?), and financial services ETFs. Investors should be careful to avoid duplication with additional ETFs tracking sub-indexes such regional banks, medical devices and aeorospace. iShares' most notable drawback is its comparatively high price at .48% annual fees.

Vanguard has a similar, comprehensive line of 10 ETFs. These Vanguard sector ETFs are based on the MSCI US Investable Market 2500, which covers 98% of the US market. (Although Vanguard literature lists its REIT fund as part of this group, it is in fact separate.) Additions from or demotions to micro-cap status are insignificant, so it is relatively efficient in terms of turnover. And having mid- and small-cap companies brings additional diversification. Furthermore, the line's annual fees of .22% leads all competitors, by a hair.

Sticking with one of these lines will all help to avoid overlap, but investors should take note of sectors which may be duplicated in other parts of their asset allocation model. Energy companies in particular are represented, so allocating further to commodities in a portfolio will really load up on assets affected by the sector. iShares DJ line includes real estate as an industry, so investors can lighten up on REITs they would otherwise have bought.

SPDR also has a small S&P line of funds targeting sectors popular for their volatily among traders in technology, health, and energy sectors. They are all sub-components of the S&P Total Market Index which covers nearly all US stocks, but obviously only a handful of industries are represented by ETFs. Investors should note that this line is equal-weighted which renders it essentially useless for accurately representing economic activity. Smaller companies are weighted far in excess of their actual size. In XOP, the oil & gas ETF, Exxon Mobil at $400 Billion in capitalization is given the same weight as Chesapeake Energy at $22 Billion. An equal weighted sector ETF makes sense only when picking a few industries opportunistically and then mostly to avoid excessive exposure to a few behemoth companies. Equal-weighting is inappropriate for most investors and most strategies.

SPDR also has a small KBW line focusing on real estate and financials. It is is capitalization-weighted and therefore representative of actual economic activity but only covers a handful of sub-indexes popular among traders. Needless to say, these plummeted during the Credit Crisis and will be a tricky trader's field for years.

This report focuses on traditional index ETFs, but there are many more ETFs which attempt to beat sector indexes with fundamental ratios or which deliver a particular strategy twist.