Unbundle The Stock Market With Sector ETFs

Investors often think about “the stock market” as if it were some kind of giant creature rumbling through the woods. However, the stock market is more like a whole bunch of little creatures, each of which can move on its own. Yes, there’s a general tendency for equities to go in the same general direction - but there are almost always exceptions.

This makes perfect sense when you think about how industries come into and out of favor with investors. Different types of businesses tend to thrive under different economic conditions.

For instance, so far this year technology is way up while utilities are mostly flat. In 2008, consumer staples were far ahead of financial services. Energy was the winner in 2007. And back in 2006 the same utilities stocks that are going nowhere this year were the hot sector to own.

Of course, knowing ahead of time which part of the market will outperform isn’t always easy. You have to do your homework and get good advice.

But once you decide where you want to focus, sector exchange traded funds (ETFs) are a great tool to implement your strategy.

Breaking Down the Market …

To illustrate how this works I want you to think about the S&P 500 Index (^GSPC) - a list of 500 large stocks selected by a committee at Standard & Poor’s. If you own SPY (SPY) (an ETF based on the S&P 500), you have a broad position in U.S. stocks: The sectors that are going up and those that are going down or sideways.

There is a way, however, to pull apart SPY and concentrate only in the sectors you want. The Select Sector SPDRs are a family of nine ETFs based on the S&P 500 - with a twist. Each of the nine includes only the S&P 500 stocks that belong to a particular industry, and there’s no overlap.

Here is the complete list of Select Sector SPDRs and the number of stocks each owns:

• SPDR Consumer Discretionary (XLY), 78 stocks
• SPDR Consumer Staples (XLP), 41 stocks
• SPDR Energy (XLE), 40 stocks
• SPDR Financial (XLF), 79 stocks
• SPDR Health Care (XLV), 53 stocks
• SPDR Industrials (XLI), 59 stocks
• SPDR Materials (XLB), 30 stocks
• SPDR Technology (XLK), 85 stocks
• SPDR Utilities (XLU), 35 stocks

Add up those numbers and you’ll get 500. If you were to buy all nine funds in just the right proportions, you would own the equivalent of a position in SPY, the S&P 500 ETF.

What are the right proportions? Because the index is weighted by market capitalization, it changes each day. So once you buy your holdings your representative portion of the S&P 500 will automatically adjust with daily market movements. The chart below shows you the breakdown as of 10/16/09.

You’ll notice that technology (XLK) currently has the biggest slice of the pie. Materials (XLB) and utilities (XLU) are tiny in comparison. This can change. A few years ago energy (XLE) was only a small part of the pie, too. Watching these changes can reveal a lot about which parts of the economy are growing and shrinking.

These ETFs are great tools to help you add exposure to sectors you like, and perhaps more importantly, avoid exposure to sectors you think are going down.

For instance, suppose you are bullish on technology. If you invest in SPY or any other broad index fund, less than a quarter of your money will be going into tech stocks …

However, if you buy XLK, you’ll get a concentrated portfolio of the largest U.S. technology companies - much more bang for your buck!

The Select Sector SPDRs aren’t the only sector-based ETFs, of course. Similar products are offered by iShares, PowerShares, and other sponsors. Each has its own unique methodology.

You can even drill down further and get more specific sector allocations. For example, in last week’s Money and Markets column I showed you how to play the different sub-sectors within the financials. You can do the same thing with technology, health care, and other sectors, too.

Sector ETFs are, for my money, one of the best investment tools ever invented. Learn more about them and I bet you’ll agree.

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