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Sector ETFs: All downside, no upside Add to ...

Abnormal Returns makes an interesting point about sector-specific exchange-traded funds: Some of them give none of the upside of an ETF (broad diversification) and all of the downside (good stock picks are held back).

The blogger is referring to ETFs - baskets of stocks that trade on exchanges throughout the day - with narrow mandates. For example, an ETF might target just software stocks or health care stocks. They appeal to investors who can't stand the thought of taking on individual equity risk, or the threat of one stock getting pulverized, but nonetheless like the profile of a particular sector.

But the problem is that some large companies dominate these ETFs anyway. As Abnormal Returns puts it: "Microsoft and Johnson & Johnson are currently third and sixth in terms of market capitalization in the S&P 500. If your aversion to individual stocks is so high you cannot muster an investment in either of these companies you probably shouldn't be investing in the respective sector ETFs either."

"We have no idea whether Microsoft or Johnson & Johnson will outperform the market or their respective sectors. However if your thesis is that these companies are undervalued then the most logical step is to invest in them directly. The perceived diversification benefits of sector ETFs will likely dilute the returns to your investment thesis."

Full disclosure: I own shares in Johnson & Johnson.

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