Building a Sector ETF Core Allocation

A sector ETF allocation gives you control over portfolio factor exposures, precise tax-loss harvesting opportunities, and flexibility to tilt toward or away from specific industries without abandoning index-based investing. The tradeoff is complexity: instead of one fund, you're managing 11 (or fewer, if you consolidate). The practical question isn't whether sector ETFs are better than total market funds. It's when the added control justifies the added complexity and how to build the allocation efficiently.

Market-Cap Weighted vs. Equal-Weight Approaches

Two fundamental architectures exist for sector ETF portfolios:

Market-Cap Weighted (Replicate the Index)

Objective: Hold sectors in proportion to S&P 500 weights

Current S&P 500 sector weights (Late 2024):

Blended expense ratio: 0.09% (same as any individual SPDR)

Why do this instead of just buying SPY?

• Tax-loss harvesting: If Financials drops 15% while Technology rises, you can harvest the XLF loss without selling your gains
• Factor control: Intentionally deviate from market weights when you have conviction
• Direct indexing preparation: You understand sector exposures before moving to individual stocks

The point is: Market-cap sector allocation doesn't automatically beat SPY. It gives you operational flexibility for tax and tilt management.

Equal-Weight Approach

Objective: Hold each sector at equal weight (9.1% each for 11 sectors)

Impact on portfolio characteristics:

Historical performance comparison (2003-2023):

• S&P 500 (Cap-Weighted): 10.1% annualized
• S&P 500 Equal Weight (RSP): 11.0% annualized
• Spread: +0.9% annually for equal-weight

Why the spread exists: Equal-weight forces you to sell winners and buy losers (rebalancing effect), captures more small and mid-cap exposure within each sector, and avoids concentration in mega-caps.

The durable lesson: Equal-weight has historically outperformed, but the spread varies by decade. In the 2010s (mega-cap dominance), cap-weighted won. In the 2000s (value recovery), equal-weight won by 3%+ annually.

Core Sector ETF Options (SPDR vs. Vanguard vs. iShares)

Select Sector SPDRs (State Street)

Universe: 11 ETFs covering S&P 500 sectors

Advantages: Highest liquidity; tightest bid-ask spreads; options markets available; longest track record

Vanguard Sector ETFs

Selected options:

Key difference: Vanguard sector ETFs track broader indices (not just S&P 500 constituents), including mid and small-caps. VGT holds 300+ stocks vs. XLK's ~65.

When to choose Vanguard: If you want more diversification within each sector and accept slightly higher expense ratios.

iShares Sector ETFs

Selected options:

Assessment: Generally higher expense ratios than SPDRs for similar exposure. Better options exist.

The practical recommendation: Use SPDRs for core sector exposure (lowest cost, highest liquidity). Consider Vanguard if broader diversification within sectors matters to you.

Sample Core-Satellite Allocations

Conservative: Market-Weight Core with Minor Tilts

Structure: 90% market-cap weighted, 10% tactical tilts

Net effect: Slight defensive tilt (underweight Tech, overweight Health Care/Staples/Utilities)

Expense ratio: 0.09%

Moderate: Equal-Weight Core

Structure: 9.1% in each of 11 sectors

Rebalancing example:

• XLK drifts to 12% (above 11.1% threshold)
• XLE drifts to 6% (below 7.1% threshold)
• Action: Trim XLK, add to XLE to restore equal weights

Expected turnover: 15-25% annually (higher than cap-weighted)

Expense ratio: 0.09%

Aggressive: Concentrated Sector Bets

Structure: 60% core (6 sectors), 40% concentrated (2-3 sectors)

Net effect: 40% in Tech + Communication Services (vs. 38% benchmark); underweight Energy, Materials

Risk: Concentrated bet on secular growth sectors; will significantly underperform if value rotates in

Rebalancing Triggers and Mechanics

Threshold-Based Rebalancing

Rule: Rebalance when any position drifts +/- X% from target

Recommendation: Use +/- 2% tolerance bands for most investors. Tighter bands increase turnover without proportional benefit; wider bands let concentration risk build.

Calendar-Based Rebalancing

Rule: Rebalance on fixed schedule regardless of drift

Recommendation: Quarterly review, trade only if threshold exceeded. Combines discipline with efficiency.

Tax-Aware Rebalancing

Rule: In taxable accounts, rebalance using:

1. New contributions (buy underweight sectors)
2. Dividend reinvestment (direct to underweight sectors)
3. Tax-loss harvesting (sell losers, buy similar exposure)
4. Direct sales only as last resort

The practical point: A sector ETF portfolio in a taxable account should minimize rebalancing sales. Use cash flows instead.

Cost Analysis: Sector ETFs vs. Single Fund

Scenario: $500,000 portfolio, 20-year horizon

When the cost is justified:

• Tax-loss harvesting generates >$300/year in tax savings (requires $10,000+ in harvestable losses annually at 25% rate)
• Sector tilts generate >0.06% annual alpha (historically plausible with rotation)
• You value precise factor control for non-financial reasons

When the cost isn't justified:

• Tax-advantaged account with no need for harvesting
• No conviction on sector tilts (just replicating index)
• Portfolio under $100,000 (administrative burden exceeds benefit)

Pitfalls to Avoid

Pitfall 1: Over-Optimization

The mistake: Holding all 11 sectors when 6-8 would suffice The problem: Managing 11 positions for $50,000 portfolio means $4,500 per position; rebalancing becomes a chore The fix: For portfolios under $250,000, consider consolidating small sectors (Utilities + Real Estate + Materials) into one broad value ETF

Pitfall 2: Ignoring Intra-Sector Concentration

The mistake: Thinking XLK is "diversified Technology" The problem: Apple and Microsoft are ~45% of XLK; it's really an AAPL/MSFT bet The fix: Check top 5 holdings concentration for any sector ETF before buying

Pitfall 3: Rebalancing in Taxable Without Tax Consideration

The mistake: Selling winners quarterly to rebalance The problem: Short-term gains taxed at ordinary income rates (up to 37%) The fix: Rebalance with new money in taxable; save sales for tax-advantaged accounts

Checklist for Building Sector ETF Core

Essential (Before Building)

• Determine objective: tax harvesting, tilting, or both
• Calculate if expense ratio premium over VOO is justified by benefits
• Choose architecture: cap-weighted, equal-weight, or concentrated
• Select ETF family (SPDRs recommended for liquidity)

High-Impact (Implementation)

• Set rebalancing thresholds (+/- 2% recommended)
• Establish rebalancing hierarchy: new cash > dividends > tax-loss harvests > sales
• Check top-5 concentration within each sector ETF

Ongoing (Maintenance)

• Review sector weights quarterly
• Execute rebalancing trades only when thresholds exceeded
• Track tax-loss harvesting opportunities during drawdowns
• Reassess architecture annually (is the complexity still worth it?)

Next Step (Put This Into Practice)

Decide if a sector ETF core allocation fits your situation.

Decision framework:

1. Is your portfolio >$100,000? (If no, stick with single fund)
2. Is a significant portion in taxable accounts? (Tax-loss harvesting value)
3. Do you have sector conviction you want to express? (Tilt value)
4. Are you willing to manage 8-11 positions? (Complexity tolerance)

If 3+ yes answers: Sector ETF core is worth considering

Implementation:

• Week 1: Calculate current sector exposures across all accounts
• Week 2: Choose architecture (cap-weight vs. equal-weight)
• Week 3: Build target allocation in spreadsheet
• Week 4: Execute initial purchases; set rebalancing calendar reminders

Action: Start with one account (preferably tax-advantaged for simplicity). Run for 12 months before expanding to taxable accounts.