Jumping into sector ETFs? Not so fast

By Morningstar

You might not have missed the party after all.

Think you've missed the energy rally? And how about those real-estate-investment trusts? After watching the way exchange-traded funds (ETFs) like iShares Cohen & Steers Realty Majors (ICF, news, msgs) have run in the past five years, you're probably wondering how to get some into your portfolio if you don't own some already.

The proliferation of sector, industry and specific asset-class ETFs has made it easy -- too easy, at times -- to find some offering that's doing better than your pokey collection of core stock funds. The Vanguard Total Stock Market (VTI, news, msgs) ETF's nearly 12% year-to-date return through October satisfies until your eyes bug out at the results of PowerShares Dynamic Telecom & Wireless (PTE, news, msgs) or streetTracks KBW Capital Markets (KCE, news, msgs), both of which gained more than twice as much over the same period. It's enough to make you want to throw up your hands and yell, "Why the heck didn't I own that?!"

Don't beat yourself up. For the most part, if you owned a broad, all-market ETF such as Vanguard Total Stock Market or iShares Russell 3000 Index (IWV, news, msgs), you did own most of the stocks in those portfolios. Nearly 90% of the holdings in PowerShares Dynamic Telecom & Wireless' Sept. 30 portfolio can be found in the Vanguard Total Stock Market ETF. Almost 98% of it can be found in the iShares Russell 3000 Index. Similarly, virtually 100% of the holdings of streetTracks KBW Capital Markets are in the two broader funds. So, if you owned one of those ETFs or something similarly broad, you probably didn't miss the party.

Sizing your wagers

You say you're well aware that sector-fund holdings can overlap with those of your existing ETFs, but you still think you can add a little juice to your portfolio's performance with some opportunistic side bets on specific market segments. Fine. But you should know what you already own in your core holdings to decide how much to devote to such wagers or whether you really need to make them.

For example, despite a recent surge in tech-stock performance, more than a third of the assets of iShares Goldman Sachs Networking (IGN, news, msgs) were in stocks trading below Morningstar stock analysts' estimates of their fair values in early November. That might make the ETF a candidate for a contrarian play for some investors. If so, a dab would probably do them if they own a broad domestic-stock ETF. Funds such as the Vanguard Total Stock Market ETF and iShares Russell 3000 Index already have significant exposure to hardware stocks, including more than 80% of iShares Goldman Sachs Networking's holdings.

Lead us not into temptation

Knowing what you own also can help you resist the allure of dumping all or some of your core funds to pursue the recent, and probably unsustainable, results of a couple of hot sectors.

Say you think the energy rally has legs -- though crude-oil price declines the second half of this year would suggest otherwise -- and you want to buy a hunk of Energy Select SPDR (XLE, news, msgs) shares. Doing so, however, would increase your energy exposure at a precarious time if you already own a diversified core stock fund like streetTRACKS Total Market (TMW, news, msgs) ETF, which keeps about 9% of its assets in energy and owns every stock the Energy Select SPDR does.

Let's look at another hot sector. Investors have not been able to get enough of real estate for most of this decade, but broadly diversified investors may already have enough of what some of the top-performing real-estate ETFs offer.

All 30 constituents of the iShares Cohen & Steers Realty Majors are in both the Vanguard Total Stock Market ETF and the iShares Russell 3000 Index. StreetTRACKS Total Market ETF held only about half of the real-estate-investment trusts in the iShares Cohen & Steers Realty Majors but still devoted 2.3% of its assets to such trusts. You may have the stomach for more real-estate exposure, but if you have one of these all-market funds, you don't need much more, especially with investment-trust valuations at historic highs.

Look before you leap

There are, of course, some more specialized ETFs that could complement core stock ETFs. You won't, for example, find many of the holdings of Market Vectors Gold Miners (GDX, news, msgs)in any U.S. total-equity-market ETFs or even in core international holdings such as iShares MSCI EAFE Index (EFA, news, msgs). That's because most of the stocks in the Gold Miners ETF are based in Canada, which isn't included in the MSCI EAFE Index or most U.S. market benchmarks. Exchange-traded vehicles that track commodity indexes, such as the iPath Dow Jones-AIG Commodity Total Return (DJP, news, msgs) exchange-traded note, or gold or silver bullion also wouldn't overlap or correlate with core equity ETFs.

Still, it's a good idea to check the holdings of any ETF you are eyeballing against what you already own, especially many of the new offerings that purportedly offer exposure to asset classes that small investors have been unable to reach in the past.

Take the new PowerShares Listed Private Equity Portfolio (PSP, news, msgs), for example. The Vanguard Total Stock Market ETF includes 15 of the 34 holdings and 73% of the market capitalization of the Red Rocks Listed Private Equity Index that the PowerShares ETF tracks. The overlap is similar for the iShares Russell 3000 Index. It's worth considering what you already have whenever you feel like you might be missing out on a specific sector's or asset class' action.

This article was reported and written by Dan Culloton of Morningstar.com.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.