ETF Sector Rotation – Part 1

by Leslie N. Masonson, MBA

Sector rotation is the practice of ascertaining and purchasing market sectors that hopefully will produce market-beating returns. The problem is sectors fall in and out of favor, similar to the changing cycles in small-caps, mid-caps, and large-caps where their dominance ebbs and flows, for months or years at a time. Sector strength or weakness is due to a number of factors, including economic conditions, financial trends, Federal Reserve (Fed) policy, government regulations, competitive industries and practices, disruptive technologies, and political instability and controversies, both local and national.

Once a sector starts moving upward from a depressed or low point, the uptrend and momentum can last for months or years. One recent example is the outperformance of oil stocks over the past 18 months, leading the energy sector to the top of the rankings scoreboard. Research has shown that about 50% of a stock’s performance is due to its industry and sector linkage, as all boats rise and fall together. Think about the semiconductor industry and the outperformance of its components since November 2022.

Before delving further into the details, let’s review the beginning of the sector fund history. Fidelity Investments is the acknowledged pioneer in the sector arena, introducing five select sector mutual funds on July 14, 1981, with the following tickers: FSPTX (Technology), FSPHX (Healthcare), FSENX (Energy), FIDSX (Financials), and FSUTX (Utilities). Later, two more were introduced in 1984 – FDLSX (Leisure), and FSDAX (Aerospace and Defense).

These funds had certain fees and strict limitations on day trading. Fidelity introduced more select sectors over the years – 20 select sectors in 1985, 6 in 1986, and 1 in 1989. In total, there are now 42 select sector mutual funds. The average expense ratio for all these funds is 0.86%, and the initial fees and restrictions on trading them have been removed. These 42 mutual funds hold billions of dollars in assets since their inception, have gained widespread acceptance, and offer top-performing sectors when conditions change.

The next major event in sector history was the introduction of sector ETFs. On December 16, 1998, State Street Global Advisors (SSgA) introduced its nine Select Sector SPDR ETF Funds. They simply divided up the S&P’s 500 stocks into nine sectors. Most investors and traders are familiar with or hold the most popular ones, including XLK (Technology), XLE (Energy), and XLY (Consumer Discretionary).

Two additional ETFs were added since 2015 for communications and real estate, as a few others gave specific stocks to comprise the two latest ETFs. The annual expense ratio of the Select SPDRs is 0.10%, and the total AUM is a whopping $242.1 billion.

Fidelity did not offer its ten sector ETFs until nearly 15 years later on October 21, 2013, with a competitive 0.08% current annual expense ratio. Their total AUM is now $18.8 billion, a very respectable showing. Obviously, in this case, SSgA, being the early bird, won the vast majority of the assets with a 13:1 AUM ratio compared to Fidelity.

The listing below provides the current Fidelity and SSgA most popular ETF sector offerings:

Fidelity Investments Sector ETFs

Since the introduction of the SSgA ETFs there has been an explosion over the past 25 years in sector ETFs for stocks, commodities, fixed income, industry and themes among others, as well as equal-weighted sectors. Currently, there are 998 sector ETFs valued at $1.24 trillion with an average expense ratio of 0.59%, according to ETFAction.com.

Next week's Part 2 article will cover sector performance and some tips on evaluating these ETFs for purchase.

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