I took a trial subscription to ETFGlobal and included in what they offer is a select list of ETFs and in scanning the list I noticed multi-factor, sector funds from John Hancock and iShares. Factor is a synonym for smart beta (usually). Something like low PE ratios would be one factor, favorable momentum would be another. So we have looked at some factor funds like the PowerShares S&P 500 Low Volatility ETF (SPLV) whose factor is of course, low volatility. A multi-factor fund combines more than one factor and there are a few broad based, multi-factor funds out there but I didn't know about multi-factor sector funds.
In taking a high level look at the industrial sector, the iShares Edge MSCI Multi Factor Industrials ETF (INDF) and comparing it to the SPDRs Industrial ETF (XLI), there are some notable differences in the top ten but for the last year through January 31, it appears that XLI outperformed by about 500 basis points. I don't view the lag as a negative. The make up of the fund and the difference in performance tells me that relative to the sector it doesn't look like cap weighted exposure. INDF is a fairly new fund. Obviously, if it were five years old and lagged for every possible time frame I might view that as a negative and that could still happen of course, there is no way to know.
In screening for broad-based tech sector funds, ETF.com's filter says there are 32 of them. The list though includes some thematic funds for some reason including mobile payments, fintech and social media. I think the correct number then for broad based tech sector funds might be more like 17, I would exclude country-sector funds from a list of broad based too, but if you care you can obviously draw any conclusion you want. I would think of market cap weighting, multi-factor, small cap, momentum and some others as being broad based and there are quite a few to choose from on the ETF.com list.
In building a portfolio at the sector level, the first step for me is to decide whether to be overweight or underweight the sector versus the S&P 500. With tech in the mid-20's I would not want to be overweight but that's not the point of this post. Then in thinking about how to build out the sector exposure, having a core in the sector of a broad based fund and then adding narrower exposures (thematic funds or individual stocks) is one way to go. I do this with tech, having held iShares US Technology ETF (IYW) for most clients since 2004, and have bought it for new clients along the way. IYW is market cap weighted, sometimes market cap weighting has been the best performer and plenty of times not. This could be said of just about all of the various broad based funds. They all capture the effect, IMO, which at a high level is the point.
Morningstar says that $10,000 invested in IYW in 2004 is now worth $38,000. If for some reason I decided that I had to switch to the latest broad based tech sector funds believing it to be superior then obviously, taxable accounts would incur a $28,000 capital gain (assuming that $10,000 initial investment) which would result in "giving away" $5600 in taxes. Occasionally, sales need to be made and taxes paid for various reasons (life circumstances and market events) but a potentially better mouse trap for a taxable account is probably a bad idea. In an IRA, this is of course no big deal. How many people have owned broad based sector funds for various sectors for many years and are sitting on large gains? I don't know, but I am thinking a lot of people and I wonder if some of the new funds won't gain traction because of this.
If you're just getting started building a portfolio or want to start to incorporate sector funds into your portfolio, I am all for it but exposures need to be monitored closely. Ending up with 40% in tech is a huge and risky bet that I think is a terrible idea for the typical investor. ETFs make it easy to know your sector exposures, it is simple math/spreadsheet work, none of which it meant to minimize a fundamental assessment or a top down assessment. If you don't want to do that work then sector funds might be a bad idea.
One final point is that in considering sector funds and the various processes for building them that you will find, it is important to understand that no sector fund can be the best for all times. Realistically any given fund will have periods of being the best, the worst and everything in between but the "wrong" broad based sector fund isn't in danger of cutting in half when the rest of them go up a bunch. The reasonable risk to the "wrong" fund is it lags like INDF/XLI example above.
*ETFGlobal did not pay me for the mention.