An exchange traded fund (ETF) is a portfolio of securities that trades on a major stock exchange similar to the way that individual stocks are bought and sold. An ETF is a basket of stocks, bonds or commodities that are valued based on the net asset value of all of the securities that comprise the fund throughout the trading day. All ETFs track the performance of another index and are designed to perform similarly to another market barometer. A sector ETF has as its underlying tracking instrument an index that is focused on one particular industry sector, such as utilities, energy or consumer cyclicals.
There are several reasons for investors both large and small to invest in a sector ETF, and cost is one of them. For instance, if there is a belief that a particular sector or category of stocks is experiencing an upward climb — that is, the values of stocks in that group are expected to rise — investors will want to benefit from those profits. One way to do this without having to hand-pick the stocks that are expected to be winners is to invest in a broader investment vehicle such as a sector ETF. Rather than investing in individual stocks within a particular sector, which can generate multiple fees from a stock broker who charges investors fees based on the number of trades that they make in the financial markets, investing in one sector ETF can eliminate several layers of fees. Also, the amount of upfront capital for investing will be less to invest in a sector ETF than it might be to purchase multiple shares of individual companies that are expected to rise in value.
There are some reasons to be cautious when one is investing in a sector ETF. For instance, this investment vehicle might trade with more volatility – market swings both upward and downward – than a traditional ETF, because the latter tend to be comprised of securities across multiple industry sectors. An ETF devoted to one given industry group has a more limited universe of securities to balance things out if trading in some of those securities goes poorly. Also, the ETF might begin to deviate from its underlying index that it is designed to imitate, which can introduce surprises to investors. This is known as tracking error, and it can be a common occurrence in both sector and traditional ETFs.