How To Invest in Sectors With These Funds

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published 5 June 2024

Asset managers such as Vanguard, State Street and BlackRock have made it easy to own individual sectors of the stock market through low-cost mutual and exchange-traded funds. But are they good investments?

The funds offer a simple way to diversify. For example, if your stock portfolio is heavy on shares of individual technology and energy companies, balancing those holdings with ETFs in sectors such as real estate and healthcare can provide a smoother ride. And a sector fund could make sense if you have a strong conviction that a particular area of the economy, such as finance, is underappreciated and will accelerate as investors recognize its true value.

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As you can probably guess, one sector has been a standout performer: technology. For the past 10 years, the average annual returns of seven out of the nine sector funds I studied fell into a narrow range, from 8.2% to 12.3%, but the Technology Select Sector SPDR Fund (XLK) averaged 20.7%. The tech fund was dominant throughout the decade: It was the top-performing sector fund in four of the past 10 calendar years and ranked in the bottom half only twice.

But you might be surprised at how some companies that most of us consider technology holdings are classified by S&P (and, therefore, State Street). For example, Amazon.com (AMZN, $180), which returned an average of 26.8% over the past 10 years, is in the consumer discretionary sector ETF, and Alphabet, Netflix (NFLX, $607) and Meta Platforms (META), the former Facebook, are all in the communications services sector fund. (Prices and other data are as of March 31 unless otherwise noted.)

The two leading holdings — Amazon and Tesla (TSLA) — account for 36% of the fund’s assets. Tesla’s miserable performance at the start of 2024 was a major reason the fund trailed the S&P 500 by seven percentage points for the year to date. Still, I am recommending the ETF for its powerful portfolio, including McDonald’s (MCD, $282), Starbucks (SBUX, $91), Home Depot (HD, $384) and several homebuilders.

For that reason, I believe a popular investment strategy called sector rotation is foolish. The idea is that you create a portfolio with disproportionate weight in certain sectors during particular phases of the business cycle and then move out of them as economic and market conditions change. For example, sector rotation favors utilities during the early stages of a recession and consumer staples during a late recovery. The strategy generates fees and time-wasting activity as you switch holdings, and there’s no evidence that it works.

“At best,” an academic paper titled “The Myth of Business Cycle Sector Rotation” found, “conventional sector rotation generates modest outperformance, which quickly diminishes after allowing for transaction costs and incorrectly timing the business cycle.” Timing the business cycle is a futile endeavor. In 2022, most economists predicted a recession was coming the next year. But gross domestic product rose 2.5% in 2023, a rate that beat the average for the decade before COVID-19 hit.

There are, however, good reasons for investors to put more emphasis on particular sectors. Technology has become the main engine of the U.S. economy. But I also like ETFs based on sectors that are out of favor, especially the Financial Select Sector SPDR Fund (XLF, $42), which returned an annual average of 10.9% over 10 years — compared with 12.9% for the SPDR S&P 500 Trust (SPY, $523), nicknamed “Spiders,” which reflects the entire large-cap benchmark.

The financial SPDR fund has its own odd characteristics. Its top holding, at 13.1%, is Berkshire Hathaway (BRK.B, $421), even though Warren Buffett’s company invests half its assets in tech (mainly Apple) and about one-fifth in finance (nearly all in insurance). Owning a bit of Berkshire, however, is never a bad idea. The rest of the fund is conventional: JPMorgan Chase (JPM), Visa (V) and the like. Another good choice is the Vanguard Financials Index Fund (VFH, $102), which is more broadly diversified and has a similar 10-year record.

My other preference for the next 10 years or so is the Health Care Select Sector SPDR Fund (XLV, $148). The population is getting older, therapies are getting better, and artificial intelligence will make care cheaper. BlackRock has ETFs that drill even deeper, such as the iShares U.S. Medical Devices ETF (IHI, $59), whose top holdings include Intuitive Surgical (ISRG, $399), which manufactures minimally invasive surgical systems such as da Vinci.

Many investors, especially those with time horizons of 20 years or more, don’t need sector funds at all. Unless you need to balance a port-folio or have a strong belief in a certain part of the economy, you can get diversification the old-fashioned way simply by owning an S&P 500 fund such as Spiders or the Fidelity 500 Index Fund (FXAIX), a mutual fund that returned an average of 13% annually for the past 10 years, beating every sector fund except technology.

James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.