The Cheapest (and the Most Promising) Sector Funds

One of My Favorites

Is Up 40%+ This Year

One knock against sector investing is that the sector-tracking funds available to investors tend to be less liquid and carry higher costs than broad market index funds. However, this complaint is no longer universally valid. Some sector exchange-traded funds now carry expense ratios as low or nearly as low as the largest and most popular stock market index funds.

The table below shows the five cheapest sector ETFs.

Lee Bellinger

Which Sectors?

There still must be good fundamental reasons to concentrate in a particular sector over the market itself before investing in a sector fund. Sectors roll in and out of favor, so ideally you want to be able to catch a sector that has higher dividends, better valuations, and/ or superior growth potential as it is bottoming or in the early stages of a bull market.

Most sectors out there are in late-stage bull markets. Some are probably in the process of topping. Now isn’t the time to go all-in on consumer stocks or healthcare and biotechnology stocks – not after they’ve had a tremendous run for several years. Now is the time to look at sectors that are starting to recover after having been beaten up. Energy is one such sector – especially the subsectors of natural gas, coal, and uranium.

We highlighted the uranium sub-sector earlier this year. Since then, the Global X Uranium ETF (URA) has broken out powerfully to the upside.

URA’s annual expenses run 0.69% — not the cheapest of ETFs, but still cheaper than most actively managed mutual funds. If you can cope with the volatility and disaster risk inherent in the uranium space, you still have an opportunity to get in early in what could turn out to be a multi-year up cycle.

Uranium stocks appear to have broken out decisively, and coal stocks could be next. Last year saw a huge breakout in alternative energy and solar equities, with positive momentum continuing to lift these subsectors so far in 2014. The Guggenheim Solar ETF (TAN) has more than quadrupled since bottoming in late 2012! Similar gains likely lie ahead for uranium and coal investors, though they may not come as rapidly.

Long-suffering holders of gold mining equities can also expect to reap very big rewards as the sector moves into a new bull market after bottoming last December. The Market Vectors Junior Gold Miners ETF (GDXJ) gained more than 40% just in the first two months of 2014!

Granted, junior gold mining stocks are speculative andnot suitable for all investors, but the potential upsideover the next 2-3 years is multiples of where prices
trade currently.

Sector Rotation
Beats Market Timing

Sector-specific investing can be hit or miss in any given year, but the approach does give you superior upside potential versus stock market indexing or even stock market timing. Moreover, it is simpler and less taxing on your time than individual stock picking. Investing in vehicles that track entire sectors doesn’t require you to research and keep up with individual companies.

As for the upside available through sector rotation, studies show that being in the right sector for the intermediate-term can generate bigger returns than getting in and out of the market at the right times.

According to Dorsey Wright & Associates, an investor who started with a $10,000 investment in 1993 and perfectly timed the stock market month to month – investing in the market during positive months and staying out during down months – would have ended up with $1.5 million by the end of 2013. As impressive as that figure is, a $10,000 investment put into the best-performing sector of the year every year since 1993 would have generated an incredible $2.7 million.

Granted, nobody is going to be able to pick the top sector of the year consistently. That’s not the objective of sector rotation. The name of the game is to be in sectors that are relatively strong or undervalued and avoid the ones that are relatively weak or vulnerable. To be successful, you need merely be more right than wrong on net.