Pitfalls to avoid when investing in sector ETFs

Sitting somewhere in between is sector investing. While there is no strict definition, it can be thought of as deliberately over- or underweighting specific parts of the market. Instead of owning the entire market, you are making targeted bets on areas like financials, energy, or technology based on your outlook.

This is top-of-mind right now due to the sector rotation we have experienced over the past six months. According to Finviz data as of March 19, the U.S. energy sector is up 32.18% year to date, while some of the mega-cap-heavy areas tied to the Magnificent Seven have lagged. Communication services is down 4.43%, technology is down 9.21%, and consumer cyclical is down 9.71%. 

Source: Finviz

Part of this comes down to macro forces. Rising geopolitical tensions, including the U.S.–Israel–Iran conflict, have sharply pushed energy prices higher, benefiting oil and gas producers. At the same time, some of the enthusiasm around artificial intelligence has cooled, with investors reassessing valuations and near-term earnings expectations for large-cap tech.

The challenge is that, while sector investing itself as a strategy has evolved, the Canadian sector ETF landscape has not kept pace in terms of fees.

In the U.S., investors have access to a wide range of low-cost options, most notably the Select Sector SPDR lineup from State Street, with management expense ratios (MERs) around 0.08%. These U.S. equity sector ETFs are also available in Canadian-dollar (including currency hedged) variants thanks to a partnership with BMO Global Asset Management at a 0.21% expense ratio.

In Canada, comparable domestic-focused offerings tend to be more expensive. A clear example is the iShares suite of Canadian sector equity ETFs, which track different industrial segments of the S&P/TSX but come with MERs closer to 0.6%.

More importantly, the way these Canadian equity sector ETFs are constructed can introduce unintended concentration risk. The limitations often come from the underlying index methodology of S&P Global rather than the ETF itself. Understanding this structural quirk is important before using any sector funds to express a sector view. Here is what to watch out for, along with some more thoughtfully constructed alternatives to consider.

When “sector exposure” becomes a stock bet

By definition, sector investing already means overweighting one slice of the economy beyond its natural market-cap weight. That is expected.

The problem is that you can end up taking on a second layer of concentration without realizing it. Instead of your returns being driven by the broader forces affecting a sector, they can end up being dictated by just a handful of dominant companies within it, with their attendant risks.

In Canada, this issue largely comes down to how sector indices are constructed. Many Canadian sector ETFs, particularly those in the iShares lineup, track S&P/TSX capped sector indices. These indices apply a 25% cap on any single holding at each rebalance.

Caps are not unusual. They exist to prevent extreme cases, such as when Nortel Networks once exceeded 30% of the TSE 300, the leading Canadian benchmark of the 1990s. That is why its successor, the S&P/TSX Capped Composite Index, has a much tighter 10% limit. At the sector level, however, a 25% cap is so high that it often fails to meaningfully reduce concentration. 

Take the Canadian technology sector as an example. The iShares S&P/TSX Capped Information Technology Index ETF (XIT) tracks just over 20 companies. In practice, roughly three-quarters of the portfolio ends up concentrated in just three names: Constellation Software, Shopify, and Celestica.

Source: iShares Canada

Similarly, the iShares S&P/TSX Capped Utilities Index ETF (XUT) is concentrated in Fortis, Brookfield Infrastructure Partners, Emera, and Hydro One. Together, these four companies account for roughly 60% of the portfolio. Again, a majority of the ETF’s risk and return is tied to a small group of stocks.

Source: iShares Canada