Sector ETFs

What a sector is, and who decides 

A sector is a classification, and like any classification it is authored by somebody. The scheme most widely used in equity markets sorts every listed company into a sector, then into progressively narrower industry groups, industries and sub industries, on the basis of where the company earns most of its revenue. A sector fund is a fund whose rule book says it holds the constituents of one of those buckets, drawn from a parent index. That is why the boundaries of a sector fund are administrative facts rather than economic intuitions: a company is in the technology sector because the classification places it there, and reclassification decisions move real money when funds are obliged to follow them.

The Select Sector family divides one large capitalisation American index into its sector components, and the catalog carries that family in full: Technology, Financials, Energy, Health Care, Consumer Discretionary, Consumer Staples, Industrials, Utilities, Materials and Real Estate. Because they partition a single parent index, the family has a property most fund groups do not. The value weighted combination of all the sector funds reproduces the parent index, so a sector fund's weight in the parent is exactly what it is being separated from.

Sector funds and industry funds are not the same thing 

A second group narrows further than the classification's top level. The VanEck Semiconductor and iShares Semiconductor funds hold one industry inside the technology sector rather than the sector itself. The Vanguard Real Estate fund holds property companies and trusts. The KraneShares China Internet fund holds a single industry in a single country. The ARK Innovation ETF is narrower again and different in kind, because its holdings are selected by a manager against a stated theme rather than by a classification rule, which makes it an actively managed fund in an exchange traded wrapper.

The distinction matters when reading a fund's behaviour. A classified sector fund moves with an index component that can be checked against the parent index. An industry or thematic fund holds a set that no parent index isolates, so its movement has no comparable reference and its composition can change on the manager's decision rather than on a published review date.

Concentration is the defining feature 

Sector funds are capitalisation weighted like their parents, and the population they weight over is far smaller. A broad market fund spreads the same weighting scheme across hundreds of companies in unrelated businesses; a sector fund applies it to a handful of large companies whose revenues respond to the same conditions. The result is that the largest two or three holdings frequently account for a large share of the portfolio, and that the remaining holdings are correlated with them, so the diversification a fund appears to offer by count is smaller than it looks.

What tends to drive each group 

Sector funds exist because the constituents of a sector respond to a shared set of conditions, and those conditions are different from sector to sector. The relationships below are conventional descriptions of how the groups have behaved, not rules, and each has failed in identifiable periods.

• Energy tracks the price of crude oil, refining margins and the capital discipline of producers, so it often moves with the commodity rather than with the equity index around it.
• Financials are sensitive to the level and shape of the yield curve, to credit conditions and to loan losses, since a bank's revenue is a spread between what it pays for funding and what it earns on assets.
• Utilities and real estate hold long dated, income producing assets and are conventionally described as rate sensitive, because their distributions are compared against bond yields and much of their financing is long dated debt.
• Technology and semiconductors carry earnings expected further into the future and an industry order cycle, so they respond both to discount rates and to demand signals from the companies that buy their products.
• Consumer staples and health care hold demand that varies less with the economic cycle, which is the basis for describing them as defensive, while consumer discretionary holds the spending that varies most.
• Industrials and materials respond to construction, capital spending and global industrial production, and materials to the underlying commodity prices as well.

Two effects cut across all of them. Sector rotation describes periods in which capital moves between these groups faster than the market as a whole moves, so sector funds can post large differences while the parent index changes little. Classification changes redraw the map: when a classification scheme moves a large company from one sector to another, every fund on both sectors must trade, and the historical record of both funds becomes an imperfect guide to what they now hold.

Hours, liquidity and reporting season 

A sector fund trades in the session of the exchange that lists it, which for the funds named here is the American equity day, with its opening and closing auctions carrying a disproportionate share of volume. Bid offer spreads on the largest sector funds are typically narrow, and they widen for narrow industry funds whose underlying holdings are themselves less liquid.

Reporting season adds a rhythm the broad market funds feel less sharply. Companies within one sector report within a few weeks of each other and comment on the same conditions, so a sector fund can move on a single large constituent's results and then again on the read across to its peers. Sector funds also distribute the income their holdings pay, and their prices step down on the distribution date in the ordinary way.