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Diversify Your Portfolio By Investing Sector ETFs

01 Sep 2023

Introduction

Exchange-traded funds (ETFs) track the movement of a basket of securities, such as stocks, bonds, commodities, or indices. They are traded on exchanges similar to shares and offer investors a convenient and cost-effective way to diversify their portfolios across different sectors, industries, or themes.

Sector ETFs narrow down to specific economic segments like banking, IT, pharma, FMCG, or infrastructure within the broader range of ETFs.

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Types of Sector ETFs

Sector ETFs can be categorised based on the underlying index or industry they track. Some of the common categories of sector ETFs are:

  • Banking: Banking sector ETFs track the performance of the banking industry, which includes public sector banks, private sector banks, foreign banks, etc. The banking sector is one of the most critical and influential sectors in the Indian economy, providing credit and financial services to various segments of society. The banking sector is also sensitive to macroeconomic factors such as inflation, GDP growth, and interest rates.
  • Information Technology: IT sector ETFs track the performance of the IT industry. It includes software services, hardware, internet, e-commerce, etc. The IT sector is one of the most dynamic and innovative sectors in the Indian economy, as it provides solutions and products to various industries and sectors across the globe. The IT sector is also resilient to domestic economic conditions as it derives most of its revenues from exports.
  • FMCG: It tracks the performance of the fast-moving consumer goods industry, which includes food, beverages, personal care, household products, etc. The FMCG sector is one of the country's most stable and defensive sectors as it caters to the basic needs and wants of the consumers. The FMCG sector is also driven by the rising disposable income, urbanisation, changing lifestyles, and preferences of consumers.
  • Pharma: It tracks the performance of the pharmaceutical industry. This sector includes drugs, biotechnology, healthcare services, and wellness products. The pharma sector is one of the most research-intensive and regulated sectors. This sector is also diversified across domestic and international markets, generic and branded products, and chronic and acute therapies.
  • Energy: It tracks the performance of the energy industry. The ETF comprises companies extracting, processing and distributing oil and gas, coal, power, and renewable energy. The global supply and demand dynamics, geopolitical factors, environmental concerns, and technological innovations also influence the energy sector.
  • Metals: Metals sector ETFs track the performance of the metals industry, which includes steel, aluminium, copper, zinc, etc. The metals sector is one of the most cyclical and volatile sectors as it depends on industrial activity and infrastructure development. Global commodity prices, trade policies, and currency fluctuations also affect the metals sector.

Advantages of Investing in Sector ETFs

  • Exposure: Sector ETFs enable investors to access niche sectors or industries that may not be well represented in the broader market indices or may have limited options for direct investment. For example, if you wish to invest in the IT sector, buy a sector ETF that tracks the Nifty IT Index and get exposure to the top IT companies in India.
  • Diversification: They help diversify your portfolio by reducing exposure to the overall market risk and enhancing exposure to specific sector risk. Suppose you have a significant allocation to the Nifty 50 Index. You may decrease your correlation with the market by adding some sector ETFs that track different sectors such as FMCG, pharma, energy, etc.
  • Low cost: They have lower expense ratios than actively managed mutual funds. They also have lower transaction costs than buying individual stocks as they trade on stock exchanges with high liquidity and low bid-ask spreads.
  • Liquidity: They have high trading volumes and market depth as they attract retail and institutional investors. This makes entering and exiting positions easier without affecting the price significantly.

Consideration Before Choosing Sector ETFs 

  • Risk-return profile: Sector ETFs have different levels of risk and return that reflect the nature and performance of the underlying sector. For example, banking sector ETFs may have higher risk and return than FMCG sector ETFs as the banking sector is more prone to economic fluctuations and regulatory changes than the FMCG sector. You must choose sector ETFs that match your risk appetite and return expectations.
  • Correlation with the broader market: Sector ETFs correlate differently with the market. Energy sectors might closely follow due to macroeconomics, while pharma sectors could be less linked. You may use sector ETFs for portfolio diversification by adding low-correlation sectors.

Conclusion

Sector ETFs are a convenient and cost-effective way to diversify portfolios across different sectors and gain exposure to various sectors' growth potential and opportunities. They offer investors liquidity, transparency, and tax efficiency. However, before investing, you should consider the sector outlook, tracking error, liquidity, and cost of sector ETFs. 

 

Related Articles: Understanding the Nuances of The Three Drives Pattern | What is a Global ETF | Nuances of International ETF | What is trading on equity

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