Choosing the Right Sector ETFs 

By Ron DeLegge, Editor

December 16, 2008

SAN DIEGO (ETFguide.com) – Do you own the right sector ETFs? It's an important question. Why? Because selecting exchange-traded funds (ETFs) that accurately represent industry sectors can make the difference between winning and losing investments.

Before most industry sector exchange-traded funds (ETFs) were born, there were HOLDRS. These were originally designed to follow stocks within specific industry sectors like banking, retailing, and technology. But as you'll learn, not all sector ETFs do a good job of representing their sectors.

Despite their ripe age, the HOLDRS still have plenty of confusion surrounding their inner workings. Even though they resemble sector ETFs the Merrill Lynch HOLDRS are actually grantor trusts that are registered and managed differently than open-end ETFs.

The grantor trust legal structure distributes dividends directly to shareholders and allows them to retain their voting rights on the underlying securities within the trust. The original securities in a grantor trust remain fixed and aren't rebalanced.

Grantor trusts are registered under the Securities Act of 1933. Some of the other financial products that follow the grantor trust structure like the HOLDRS are the SPDR Gold Trust (NYSEArca: GLD), iShares Silver Trust (NYSEArca: SLV) and the Rydex CurrencyShares.

Instead of charging an annual expense ratio, HOLDRS charge an $8 annual custody fee per every 100 shares or round lot owned. Also, unlike traditional ETFs, HOLDRS can only be purchased in 100-share or round lot increments. That means if you want to buy 50 shares of a HOLDR, you're out of luck.

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Other important differences between HOLDRS and ETFs shouldn’t be missed.

Traditional ETFs are designed to track a specific index or benchmark. As stock or bond holdings in the underlying index are added or deleted, the ETF manager makes the necessary adjustments. The idea is to closely replicate the performance of the underlying index.  

In contrast, each of the HOLDRS is a predefined collection of stocks in a particular industry sector. As stocks within a particular HOLDRS merge or disappear, they aren’t replaced or rebalanced. As a result, HOLDRS have the tendency to become concentrated in the remaining stock holdings with the passage of time. This creates lots of volatility, which is one of the reasons HOLDRS are such a hit with volatility addicted traders. On the other hand, volatility is what most investors strive to avoid.  

One of the main faults of the HOLDRS is their distorted representation to their respective industry categories.

For example, the Internet HOLDRS (NYSEArca: HHH) owns only 12 Internet stocks. How can such a narrow portfolio provide an accurate reflection of the ever changing and diverse Internet sector?

Noteworthy omissions from HHH are industry leaders such as Expedia, Google, IAC/Interactive, and Monster Worldwide Inc. If you want a truer or more accurate picture of the Internet space, see the First Trust Dow Jones Internet Index Fund (NYSEArca: FDN). This particular ETF as roughly 40 holdings that are periodically rebalanced and maintained by an indexing committee.  

The same problem of accuracy in sector representation arises with the 16 other sector focused HOLDRS.

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Look at the Retail HOLDRS (AMEX: RTH) which has exposure to just 18 stocks. This is far too few stocks to accurately represent the business and commerce in the diverse world of consumer retailing. On the other hand, competing ETFs that follow the consumer sector like the SPDR S&P Retail ETF (NYSEArca: XRT) and the Consumer Discretionary Sector SPDRs (NYSEArca: XLY) do a better job of accurately representing the equity performance of retailers. XLY owns 81 stocks and XRT has 55.

The only reason RTH's performance has held up slightly better compared to XRT and XLY is because of its disproportionate exposure to Wal-Mart Stores (NYSE: WMT). Even though Wal-Mart has been one of the few bright spots this year in retailing, any future missteps or problems could trigger outsized losses for investors in RTH.

One last example of sector distortion is illustrated in the heavily traded Oil HOLDRS (AMEX: OIH). This particular HOLDR aims to represent the energy and oil services sector, but with just 16 stocks, it does a poor job. Furthermore, OIH's top three holdings Transocean, Schlumberger, and Halliburton represent almost 40% of the fund's total weighting! When, besides never, should three stocks ever represent 40% of an entire industry sector?

Then too, there's the issue of performance. Since the beginning of the year, OIH has crumbled by nearly 59%, which is substantially worse compared to corresponding energy/oil ETFs like the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEArca: XOP) and the Energy Sector SPDRs (NYSEArca: XLE).

As the $50 billion Madoff heist shows, investors - even at the highest levels - still consistently fail to do their due diligence. Everyone wants the quick and easy profits, without doing any work. Could it be that millions of ETF investors own sector ETFs that aren't doing what they're supposed to be doing?

ETFguide's Profit Strategy Newsletter continues to recommend best-in-class ETFs that have the potential not just for big profits but those that accurately represent the markets they're attempting to track. Ultimately, investors will have to make the final call on whether the HOLDRS can hold their own. We happen to think they don't.