Diversifiable Risk in Sector ETFs

Energy stocks are the big loser this year as oil continues to get crushed. The SPDR Energy ETF (XLE) is down almost 14% while the S&P 500 is up over 11% in 2014.

ETFs are widely considered to be the equivalent to an index fund, and in many ways they are, but it all depends on what your definition of an index is and what you’re trying to accomplish. Any S&P 500 or total stock market fund is going to be broadly diversified with hundreds or even thousands of individual securities. Diversifiable risk is minimized in these types of funds. This is not the case in specialized ETFs that invest in certain sectors or segments of the market.

XLE holds just 42 companies. Exxon Mobile (XOM) alone makes up almost 17% of XLE. Chevron is another 13% of the total. Both of these stocks are down double digits on the year. Of course, it makes sense that the sector ETFs would have a smaller number of holdings since collectively they make up the S&P 500. It’s just something for investors to be aware of.

Here are each of the nine S&P 500 sector ETF along with the concentration of each in their top ten holdings:

Sector Holdings

On average, between the nine sectors, the top ten holdings account for 55% of the market value. For comparison purposes I listed the S&P 500 to show that the top ten companies make up just under 18% of the broader market. There’s nothing wrong with having conviction in an investment theme, but you have to be willing to deal with much higher volatility if you make a high conviction investment.

The average range of returns in the S&P 500 between the top and bottom performing sectors since 2004 is 35%. That’s a huge gap within a broad market index. That means higher rewards if you’re right but higher risks if you’re wrong.

You have to understand what you’re getting yourself into with concentrated position-sizing. Many don’t. In fact, you could argue that sector or specialized ETFs make it much easier to invest in a certain theme without having to dig too deeply into individual companies.

One of the best parts about the proliferation of ETFs is that individual investors are now offered low-cost products in strategies that would have been nearly impossible for them to put together in the past. This is a huge breakthrough for the average investor. But it really matters how you utilize the more specialized ETFs within an overall portfolio construct and whether you understand the risks involved.

For more on concentrated ETFs, read my interview with Wes Gray:
Q&A with Alpha Architect’s Wes Gray

Further Reading:
How Sector Rotation Wreaks Havoc on Investors
The Equal-Weighted Sector S&P 500
What’s the Relationship Between Oil Prices & The Stock Market?

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  1. Jim Haygood commented on Dec 11

    The concentration in cap-weighted sector funds bothers me too. One way to get around it is to use Guggenheim’s equal-weighted sector funds. Since the end of 1989, they’ve outperformed the cap-weighted sectors … in every sector except energy, where the cap-weighted fund won by about 0.3%.

    Of course, the equal-weighted sectors can’t match the vast liquidity of the Sector SPDRs. But their liquidity appears to be adequate for individuals to trade.

    • Ben commented on Dec 11

      True, as long as you’re willing to accept more small/mid exposure. Always trade-offs, but I like the equal-weights like you do.