What are sector-specific ETFs?
Exchange-traded funds or ETFs are an investment product that have gained increasing popularity since their inception in 1990. These investments which hold a basket of securities offer investors the ability to be exposed to a range of various sectors and asset classes. The following article will outline the difference between sector-specific and thematic ETFs which involves a discussion of the benefits, risks and costs associated with this form of investment.
What are ETFs?
An ETF is a managed fund that investors can buy and sell on an exchange in the same way they can with a direct share. In Australia, these products are usually passively managed, and the value of the ETF will rise and fall in accordance with the index it tracks. ETFs have had positive performance in Australia and grew 30.4% to $79.3 billion in assets in 2020, reaching a five-year high of $18.7 billion.
What are the key features and benefits of ETFs?
The main benefit of this form of investment is that they are lower cost compared to other investments such as traditional managed funds which are actively managed and therefore incur greater management costs. Another key advantage of ETFs is that they offer investors broad exposure to a variety of assets and industries within a single holding. This could include companies listed on the ASX200 or S&P500 whilst also offering exposure to industries such as energy, healthcare, property and technology. Another benefit of ETFs is that they are liquid investments and can be sold and traded on exchanges such as the Australian Securities Exchange. This has led to ETFs proving popular with individuals who wish to invest but have limited capital and therefore have been coined a ‘convenient vehicle for low-cost diversification.’
What is the difference between physical and synthetic ETFs?
Simply put, ETFs can hold physical assets and therefore the underlying securities that the index is comprised of can be purchased. This could even be a tangible asset such as gold. Conversely, ETFs can also be invested in synthetic assets whereby derivate products are used instead of physical assets. This in turn can reduce costs in comparison to holding the physical assets and also offer investors the opportunity to invest in commodities and currencies.
Thematic ETFs vs Sector-Specific ETFs
When deciding the most appropriate ETFs for your specific investment strategy, the criteria used to make this decision will vary from person to person. However, thematic ETFs are becoming increasingly popular to achieve exposure to specific market trends. This is different from sector-specific ETFs which have a focus on a particular sector or asset class.
This can be understood in the context of the information technology sector. Investors following a sector-specific approach and wanting to invest in IT would simply consider companies within this industry. However, a thematic approach would look beyond the companies that directly operate within the sector to other companies which operate concurrently to the sector and may benefit from positive performance in the immediate industry.
A hypothetical example of this would be if an individual wanted to invest in companies directly related to IT such as Apple or Microsoft, would also invest in Amazon or Netflix as they would likely benefit from the collateral growth due to a rise in the information technology sector.
What are the risks associated with this form of investment?
The first consideration which investors need to take into account is that investing in sector-specific ETFs provides you with exposure to a very concentrated portion of the overall market. Due to this narrow focus, the value of your investment may experience greater volatility due to reduced diversity. This could mean that your investments could have steep growth but could also have equally as large losses.
Compared to more diverse ETFs, sector ETFs do cost more due to the reduced economies of scale, less industry competition and increased costs of investing. This is important to consider as it may have a negative impact on the overall returns of your sector-specific ETF.
Another challenge for this form of ETF is that they capitalise on market trends which is ultimately reliant on identifying the trend at the right time and with sufficient time to benefit from it. Therefore, there is an increased timing risk which may not be as prevalent for investors who focus on time in the market.
In conjunction with this, there is also the risk for ETFs which support a particular trend and the projected performance does not materialise. As the ETF is predominantly exposed to that sector, this will mean that investors bear the brunt of the potential downturn as they are not exposed to a diverse range of industries beyond the specific sector.
With any financial decision, it is important to consider all the risks, costs and benefits of the options available to you. If you would like assistance with your specific investment strategy and how it aligns with your financial goals and objectives, please click the link to organise a complimentary 20-minute phone call with an EPG Wealth adviser.