Sector-based exchange-traded funds (ETFs) can be part of an effective investment strategy for clients who believe a specific sector offers better relative value than the broader market.

“Sector ETFs are, by far, the go-to tools for investors looking to fine-tune or overweight their sector exposures,” says Pat Chiefalo, managing director and head of iShares Canadian product with BlackRock Asset Management Canada Ltd. in Toronto.

Adds Barry Gordon, president and CEO of First Asset Investment Management Inc. in Toronto: “[Sector ETFs] provide an opportunity for clients to achieve focused exposure to a part of the market in which they have high conviction.”

When your client invests in a sector-based ETF, he or she is making a tactical call in the belief that the sector offers better relative value, says Jaime Purvis, executive vice president, national accounts, with Horizons ETFs Management (Canada) Inc. in Toronto. “Whether you outperform or underperform the broad index depends on whether you overweight or underweight that sector.”

In today’s market, there are several sectors to consider that may enhance clients’ returns. Gordon and Chiefalo suggest that the beaten-up energy sector is starting to look interesting as oil prices begin to stabilize. Examples of energy ETFs are Horizons S&P/TSX Capped Energy Index ETF and iShares S&P/TSX Capped Energy Index ETF.

With sentiment among U.S. homebuilders turning bullish and building permits for private U.S. homes on the increase, U.S. homebuilders may be poised to outperform, says Tyler Mordy, president and co-CIO at HAHN Investment Stewards & Co. Inc. in Toronto.

Mordy says clients should be aware that the risks and rewards of sector ETFs are largely dependent upon industry specifics. For example, he says, a financial services sector ETF would have greater interest rate risk and more sensitivity to changes in the yield curve than an energy-sector ETF.

“The biggest single risk of sector-based ETFs,” Gordon adds, “is also the biggest potential reward.” That risk is the tendency to have higher volatility, which can lead to outsized gains or losses.

Purvis notes that Canada is a tricky market for sector investing because it is heavily weighted in just three sectors – financials, energy and materials. Regardless of which sector your client chooses for an investment, Mordy says, there are a broad range of ETF strategies from which to choose.

– “Vanilla” sector ETFs

“Vanilla” sector ETFs, such as iShares S&P/TSX Capped Financials Index ETF, track the performance of a specific sector and do not include the use of leverage or inverse exposure. Or, Chiefalo says, you can reduce the broad market’s concentration in Canada’s largest sectors by investing in sectors such as consumer staples or utilities by using, for example, iShares S&P/TSX Capped Consumer Staples Index.

– Leveraged sector ETFs

If your clients want to take a little more risk, they can invest in leveraged sector ETFs, which track the performance of a specific sector and are leveraged in such a way that an ETF provides two or three times the exposure to the underlying index, Mordy says. For example, if a sector appreciates by 0.5% in one day, a 2:1 leveraged sector ETF would be expected to appreciate by 1.0% that same day. An example of such an ETF is Horizons BetaPro S&P/TSX Capped Financials Bull+ ETF.

– Leveraged inverse sector ETFs

Leveraged inverse sector ETFs track the inverse performance of a specific sector and use 2:1 or 3:1 leverage. For example, if a sector depreciates by 0.5% in a single day, the leveraged inverse ETF with 2:1 exposure is expected to appreciate by 1.0% that same day. An example of such an ETF is Horizons BetaPro S&P/TSX Capped Financials Bear+ ETF.

With all leveraged ETFs, it’s important to monitor your client’s daily exposure – particularly if hedging is involved – to ensure that the exposure is still in line with your client’s investment goals and objectives, Purvis says.

– Inverse sector ETFs

Inverse sector ETFs provide a good way to hedge against sector risk, Purvis says. These ETFs track the inverse performance of a specific sector. For example, you could buy a 2x inverse ETF, which, for example, would effectively hedge your financials stock exposure if you are long on financial stocks while, at the same time, you continue to hold those stocks and earn the dividends they pay.

Gordon cautions that inverse sector ETFs are more complicated because your clients are getting exposure through derivative contracts underlying the ETF: “They may provide a return profile that is quite different from what you may expect.”

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