Should you invest in sector funds?

The MoneyWeek exchange-traded fund (ETF) portfolio holds most of its equity allocation in broad funds: US, Europe, Japan and emerging markets. 

However, there are many other ways to slice up markets, such as sector, size, factor (stocks with specific characteristics such as high yields or low price/earning ratios), thematic and more. 

Given that many companies – especially larger ones – depend on the state of the global economy more than the country where they have their main listing, this may seem like a more sophisticated approach. 

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So why not ignore geography and build a portfolio using sector trackers to reflect which sectors offer the best value?

How ETFs work

Before considering this, it’s important to note that not all sector funds offer exactly what an investor would expect from their names. 

Take the MSCI World Communications Services index, for example, which sounds like it will be mostly telephone companies. Historically, that was largely the case. However, in 2018, changes to the global industry classification standard (GICS) – the industry categories used for companies – put Alphabet, Meta Platforms, Netflix and Disney in the sector. As a result, Alphabet and Meta now account for more than 50% of the index. A tracker for this is not going to behave like a collection of telecommunications stocks (which might be a relief, given the poor long-term returns of many telcos). 

Or take consumer discretionary, a category that seems as if it should be about fashion and leisure. Yet about 20% of the index is automakers, which are definitely a big, discretionary purchase but have very different dynamics to McDonald’s.

MoneyWeek’s ETF portfolio

Another 20% is in Amazon, which is a key part of the consumer economy but is more about logistics and data centres than making and selling goods. 

Out of the giant tech megacaps, only Apple and Microsoft fall into the MSCI World Information Technology index. And why Apple, which is as much about fashion and branding as tech (and earns luxury-style margins as a result) and is less a consumer-discretionary stock than Amazon, is not easy to explain. 

In any case, given the huge US weighting in this index (almost 90% of the total), arguably a Nasdaq-100 tracker gives much better exposure to tech than a dedicated world tech ETF.

A core of cheap broad funds is best

Not all sector funds are useless. Energy, real estate, healthcare and consumer staples mostly offer what their names imply. 

The MoneyWeek portfolio held an energy ETF until recently as a hedge against inflation. It also holds a real-estate income ETF, the next holding to be reviewed, with UK mid caps afterwards. 

But building an entire portfolio around sector trackers would be a messy process and would push up costs. Holding a core portfolio of cheap, broad funds and using specialist ETFs to add specific exposures is a more effective option.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.