ETF ACADEMY: Sectors or Stocks?

In this past weekend’s New York Times, Mark Hulbert discusses a recently published paper with important implications for investing with ETFs.

The paper’s title is “Mutual Fund Industry Selection and Persistence” and authors Jeffrey Busse and Qing Tong find that, when it comes to mutual fund performance, selecting the right industry is about as important as selecting the right stock. In other words, about half of the performance that a manager achieves by investing in Deere & Co. (NYSE: DE) can be explained by the initial decision to invest in the farm equipment industry.

That finding is probably not a big surprise to most investors. However, the authors go on to report that time eventually erodes the managers’ ability to continue pick the right stocks but time does not affect managers’ ability to pick the right sectors. This is true even for managers of wildly successful funds who eventually attract so much capital that they are unable to maintain their stock selectivity.

Busse and Tong point to prior research that found consistent industry selection can explained by a manager’s ability to time industry allocations across the business cycle and maintain larger exposure to the energy, utilities and metals industries.

This finding is important to ETF investors because it validates a fundamental hypothesis of exchange traded funds investing – it is better to make low cost, diversified bets on sectors and industries than it is to make expensive and risky bets on individual securities.

Not sure which sectors or industries to invest in? See our recent posting on Rebalance vs. Rotation for suggestions on Rotation ETFs.

The Busse and Tong paper is available at the SSRN eLibrary.

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