In a follow up to the previous posting on PowerShares’ suite of small-cap sector ETFs, the beauty of sector plays is that you can follow a trend without taking single stock risk.
For instance, if you think oil is going to go up in price you might want to purchase stocks of some oil companies. Let’s take an example from 2006 when oil was surging. In this case, you bought BP, the formerly named British Petroleum, at the beginning of 2006. Over the course of that year BP experience some serious problems, such as a refinery explosion that killed 15 people in Texas. It later came out BP had suffered a series of deadly incidents due to poor safety standards. Then BP had two big oil spills in Alaska and managers were later indicted and fined for manipulation of the crude-oil and propane markets. By the end of 2006, BP’s stock was flat but ExxonMobil had jumped about 30% on surging oil prices.
This is called single stock risk and the problem is obvious. You made the right call on oil, but you picked the wrong stock. You just happened to pick the oil stock that was subsumed with scandal. However, if you buy a sector ETF holding large-cap oil stocks, you get instant diversification because you own shares of many oil companies. You capture the upside in the oil prices and in this case, one bad stock has a negligible effect on the portfolio.
Daily Finance has a broader look at how to become a savvy investor in sector ETFs.