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Battle market volatility with sector ETF funds

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Energy. Health care. Technology.

Advisors on behalf of their clients can choose to invest in a sector exchange-traded fund that mimics most individual sectors of the economy, or they can take a broader approach across various sectors.

Sector investing, which offers flexibility and diversification -- two distinct advantages amid volatile markets -- is gaining momentum with advisors.

“Sector ETF funds are ideal building blocks for a portfolio because each sector acts like its own economy and reacts very differently to factors in the market or economy. This divergent nature creates a high level of diversification,” said Chris Cook, president of Centerville, Ohio-based Beacon Capital Management, with assets under management of $2 billion.

The investment strategy is pretty straightforward. Sector ETF funds, also known as specialty funds, concentrate their equity investments in a single sector of the economy, such as technology, consumer staples or metals, allowing investors to target their exposure.

Advisors can access individual sectors by investing in a mutual fund or a sector ETF fund.

The allure of sector ETFs as opposed to mutual funds is that they often cut costs, provide transparent pricing, can be sold throughout the day and provide greater diversification than owning an individual stock.

Some specialty ETF sector funds drill further into subsectors, such as biotechnology, while others track specific indexes, such as the well-known SPDR ETF fund, for example, which seeks to mirror the returns of the Standard & Poor’s Financial Select index. Another ETF sector fund, ALPS Equal Weight, delivers exposure to the wide U.S. large-cap equity market.

The equal-allocation approach favored by Cook and other ETF managers, calls for weighting assets equally between nine or 10 sectors, which is the traditional portfolio management approach. For greater flexibility, Beacon Capital Management adds real estate as the 11th sector and eschews international, thinking its 11-sector approach in totality has international exposure because of the correlations happening throughout the world.

Cook also noted that international ETF funds are typically more expensive than domestic ones.

Fund tracker Morningstar counts 322 ETF investments that fall into one of its sector categories. ETF sector funds get a Morningstar star rating when the criteria for a rating is met and the category has enough investments to be rated.

Sector ETF funds aren’t without challenges similar to all ETF funds, though, said Tom Lydon, editor and proprietor of ETFtrends.com and president of Global Trends Investments in New York, which is a registered investment advisor.

When selecting a sector ETC, he recommends choosing one that is large enough and has strong trading volume and also that advisors be sure they aren’t just buying a handful of stocks instead of a diversified index.

SPDR Sector ETFs could be a good selection “because they have been around the longest,” Lydon said.

Bruce W. Fraser, a New York financial writer, contributes to Financial Planning and On Wall Street magazine.

This story is part of a 30-30 series on smart ETF strategies.

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