The Basics of Sector ETFs

The Motley Fool has helped ordinary people become better investors for nearly two decades. This month, we're reaching out to millions of investors to help guide them in their quest toward financial knowledge and independence.

Along those lines, I'm planning to take a look at different exchange-traded funds available to investors today. ETFs have skyrocketed in popularity, but it's important to understand exactly what you're getting when you buy an ETF. Today, I'd like to take a broad look at sector ETFs, which let you drill down on a particular part of the market.

The right mix of diversification and concentration
Exchange-traded funds have become one of the most useful tools investors have. By giving you a diversified investment in a single package, which you can nevertheless buy and sell at will whenever the market is open, ETFs offer a lot of flexibility.

Initially, many of the first ETFs available to investors tracked extremely broad segments of the market, such as the S&P 500. That was great for those who subscribed fully to the passive investing philosophy, which recommends simply trying to match the market's performance, rather than beating it.

But many investors believed that they could outperform the indexes by choosing stocks from more promising industries while avoiding less successful ones. At the same time, they didn't want to guess which company would prevail over its competitors; they just believed that an industry in general would outpace the broader market.

In late 1998, the SPDR family of ETFs came out with sector ETFs based on the industries in the S&P 500. With nine different ETFs making up its Select Sector SPDR group of ETFs, investors could own shares of all the S&P 500 stocks that fell into a particular industry. And with annual expenses of just $18 per $10,000 invested, that diversification came at a reasonable cost. Since then, a host of other sector-specific ETFs have come out, competing with the SPDRs and using different strategies to pick stocks.

Things to watch out for
Although Select Sector SPDRs are useful in giving you exposure to dozens of stocks, their market-cap weighting sometimes creates unexpected concentration. For instance, in the Energy Select Sector SPDR, more than a third of your money will go toward just two stocks: ExxonMobil (NYS: XOM) and Chevron (NYS: CVX) . Those integrated oil giants play a big role in the industry, and their fortunes are largely tied to those of their peers. But if you're hoping to score big on a new oil discovery, you'll want to try to pick individual stocks to add to a core ETF holding.

You can find similar concentrations in other sector ETFs. Apple (NAS: AAPL) by itself makes up 21% of the technology sector ETF, while the top four stocks in the consumer staples SPDR, which include Philip Morris International (NYS: PM) and Procter & Gamble (NYS: PG) , add up to 45% of its total assets.

Again, those concentrations may be perfectly acceptable for you. Apple has certainly rewarded those bold enough to allow the hot technology stock to keep its highly weighted position in their portfolios, with shares having punched above $700 yesterday on solid iPhone sales. Meanwhile, consumer stocks like Philip Morris and P&G provide much-needed ballast for conservative investors, and Philip Morris in particular has been a lucrative way to invest in tobacco while avoiding many of the regulatory problems of U.S.-based tobacco companies.

But the key to sector ETFs is to know the exact mix of concentration and diversification you're getting. If you don't know about it, you can't prepare for it, and that's important if you're looking to sector ETFs to help you get a broad spectrum of different stocks in a particular industry. Moreover, because there are so many different flavors of sector ETFs out there, becoming familiar with each one's particular quirks can help you pick the one that exemplifies the attributes you're looking for.

Learn more
To find out more about one set of sector ETFs, take a look at the home page for the Select Sector SPDRs. In addition, check out the Fool's coverage of various sectors to give you an idea of which ones may be best suited for your investing needs. For instance, our premium report on Apple will give you broad insight on the entire technology sector, as well as in-depth detail on the company itself -- and a year of free updates! Click here to claim your investing edge.

Please stay tuned throughout the month for other informative articles covering a wide range of important topics. Let me also encourage you to take a look at the special website we've set up at InvestBetterDay.com. On Sept. 25, we're taking a day to celebrate the art of investing, and we encourage your participation. Take a look at the site now and get on the path to personal prosperity.

The article The Basics of Sector ETFs originally appeared on Fool.com.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article, although he does own some other sector ETFs. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Chevron, Procter & Gamble, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy likes giving you the basics.

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