Sector & Thematic ETFs: Rotations, Megatrends and How to Play Them

Before delving into how to deploy sector and industry ETFs for success and to properly evaluate thematic ETFs, defining sector ETFs is a necessary step. Consider it a preventative step that ensures investors aren’t deceived by fund names or end up buying something that’s undesirable or full of surprises. It starts with what’s known as the Global Industry Classification Standard (GICS).

“GICS® is an industry analysis framework that helps investors understand the key business activities for companies around the world. MSCI and S&P Dow Jones Indices developed this classification standard to provide investors with consistent and exhaustive industry definitions,” according to MSCI.

Put simply, GICS is used by major index provides, like MSCI and S&P, to define sectors and from there, differentiate the various industries within those sectors. That’s right. Sectors and industries are NOT the same thing, though the terms are often used interchangeably. Sectors, and thus the related ETFs, are broad while industries and the ETFs tied to them are more laser-focused.

With all that in mind here are the 11 official sectors in alphabetical order: communication services, consumer discretionary, consumer staples, energy financial services, healthcare, industrials, information technology, materials, real estate and utilities.

The major index providers classify publicly traded companies based on sectors, industry groups, industries and sub-industries. From there, the firms are assigned GICS scores based on that quartet of tiers with revenue being a major determining factor in what sector a corporation is placed in.

“Earnings and market perception, however, are also recognized as important and relevant information for classification purposes, and are taken into account during the annual review process,” notes MSCI.

Bottom line: A traditional sector ETF like the Technology Select Sector SPDR^® Fund (XLK) takes a broad approach to the sector noted in its name, addressing multiple industries under one umbrella and, depending on the depth of the sector, holding a fair number of stocks in the process.

Investigating Industry ETFs

Relative to sector ETFs, industry ETFs introduce a small though not daunting level of complexity investors need to acknowledge. It boils down to simple math, within the 11 aforementioned sectors, there are 25 industry groups, nearly three times as many official industries and 163 sub-industries.

That’ a lot of sub-industries and some are too small on a revenue basis to for ETF issuers to consider introducing related products. However, don’t put it past ETF sponsors to push boundaries when it comes to industry ETFs. Today, investors can access ETFs addressing hotels (consumer discretionary sector) and “green REITs” (real estate sector).

Getting back to the basics of what makes an industry ETF, it’s typically a fund that addresses a large, well-known segment halved off from a sector fund. Consider the industries addressed in the aforementioned XLK: technology hardware, storage and peripherals; software; communications equipment; semiconductors and semiconductor equipment; IT services; and electronic equipment, instruments and components industries.

Translation: An investor purchasing a semiconductor ETF is indeed buying a tech fund, but they’re purchasing an industry ETF, not a sector fund, because semiconductor ETFs only hold chip stocks. Another easy-to-understand example is biotechnology and healthcare. The former is an industry while the latter is a sector so when you allocate to a biotech ETF, you’re getting involved with an industry fund, not a sector product.

Indeed, industry ETFs present investors with significant potential, but these products are reminders that due diligence and knowing what’s under the hood are vital concepts as is accounting for risk.

“Industries have historically exhibited wider dispersion than broad sectors due to their larger investment opportunity set,” notes State Street Investment Management. “The gap between the best- and worst-performing industries has been consistently wider than that of sectors. Since correlation between industries in the same sector is less than 1,¹ greater alpha opportunities may exist at the industry level due to unique industry drivers.”

Talking Thematic ETFs

As the ETF industry has evolved, so have the sector and industry offerings accessible to market participants. Long gone are the days when sector ETFs were confined to the basics of the GICS grouping and the era of industry-level ETF investing that was limited to the likes of aerospace and defense, biotechnology and semiconductors.

Thematic ETFs, a fast-growing segment of the broader ETF industry, are drivers of that evolution. These days, investors can tap hundreds of thematic ETFs providing exposure to concepts ranging from artificial intelligence (AI), cloud computing, cybersecurity, electric vehicles (EVs), meme stocks, pet care, renewable energy, sports betting and much, much more.

“The biggest difference between thematic and sector ETFs is that sector ETFs group companies together by specific fields of business activity, while thematic ETFs seek to identify companies that are involved in a specific theme or global trend irrespective of their economic sector,” notes Invesco. “A theme is often associated with disruptive technologies, such as clean energy, blockchain, robotics or other technological innovations.”

In essence, thematic ETFs live up to their billing by providing exposure to themes or trends. For tactical investors, that accessibility is pertinent for multiple reasons. First, many of the themes addressed by thematic ETFs, particularly those with technology ties, are rapidly growing. They’re also showing considerable staying power. Think AI and cybersecurity as just two examples.

Second, many broad market ETFs don’t provide adequate exposure to specific themes. Due to the magnificent seven, AI is an exception to that issue, but broadly speaking, a basic S&P 500 ETF isn’t the place to be for an investor seeking dedicated exposure to cycbersecurity, fabless semiconductor equities, gaming stocks or renewable energy names, among others.

That is to say thematic ETFs can be complements to broad market, pure beta fare. Owners of S&P 500 or total market ETFs that hold hundreds or thousands of stocks can pair those investments with thematic ETFs to gain the targeted exposures they desires while potentially positioning portfolios for enhanced returns. Thematic ETFs are potentially advantageous for another reason: stock-picking is difficult and that’s certainly true in industries and among themes.

(Image: State Street Investment Management)

Business Cycle Benefits with Sector, Industry ETFs

Sector and industry ETFs and even some of their thematic counterparts are also relevant plays on the business cycle because certain sectors outperform or lag depending on the macro phase. Decades of data show that leadership rotates as the economy progresses from recession to recovery, expansion, late cycle and ultimately contraction. Rate‑sensitive sectors such as consumer discretionary, financials and real estate tend to do best early in the cycle when interest rates are low and economic activity is rebounding.

Economically sensitive industrials, information technology and materials also benefit from renewed spending. As the cycle moves into mid‑cycle expansion, leadership becomes less clear; technology and communication services often continue to perform well while materials and utilities lag. During late‑cycle phases, inflationary pressures build and energy, consumer staples and utilities historically lead while growth sectors like information technology and consumer discretionary lag.

In recessions, defensive sectors such as consumer staples, utilities and health care have typically outperformed because they provide essential goods and services. The table below summarizes these relationships.

(Image: Interactive Brokers)

Investors can use this framework to tilt their portfolios: overweight rate‑sensitive and cyclical sectors during early recoveries, rotate toward technology and communications during mid‑cycle, and shift to defensive energy and staples as the expansion matures.

When a hard landing looms, increasing exposure to consumer staples, utilities and health care may help cushion downside. Aligning sector allocations with the business cycle—then refining with momentum screens—can enhance returns and manage risk.

Vetting Thematic ETFs

Getting down to brass tacks, thematic ETFs aren’t “perfect” – no investment is – but they offer a lot of utility. The secret is using those funds the right way and that starts with a robust vetting process. Don’t worry. It’s not hard as much of it boils down to knowing what you own or about to own. That’s easily accomplished by looking at issuer websites. Remember that unlike mutual funds, ETFs update their holdings on a daily basis so there are unlikely to be holdings-level surprises for investors that do their homework.

Don’t stop there. Some investors may look at a thematic ETF and compare the components to an already broad market fund, see some similarities and move on. Investors that make that mistake are being tripped up by overlap of holdings, but what really matters is overlap by weight.

Fortunately, it’s easy to screen for that. Use the nifty fund overlap tool courtesy of the ETF Research Center. In the “Fund 1” field, enter the ticker of an ETF you already. In the “Fund 2” field, input the ticker of a thematic ETF you’re considering. For the purposes of this exercise, we compared the SPDR S&P 500 ETF Trust (SPY) and the Global X Artificial Intelligence & Technology ETF (AIQ). Click “find overlap” and you’ll see something like this:

(Image: ETF Research Center)

In a matter of minutes, you’ve vetted a thematic ETF to ensure it really can freshen up your portfolio while avoiding adding duplicative exposures. It’s an easy task and worth committing to for investors that want to maximize the benefits associated with thematic ETFs. Just remember KYH—know your holdings.

Watch for concentration risk and overlap

Because thematic ETFs funnel capital into a narrow group of companies exposed to a single trend, they can be more volatile than broad‑based funds. An investor chasing a hot theme may find that a few large positions drive a disproportionate share of returns, which increases concentration risk and can magnify drawdowns when the theme falls out of favor.

It is therefore important to look beyond the marketing copy and dig into the fund’s weighting scheme and top holdings. Two funds tied to the same concept can have wildly different allocations to the “hero” stocks, so an overlap tool helps gauge how much incremental exposure a new ETF brings to your portfolio.

Free research from the ETF issuer’s site and third‑party databases makes this process straightforward. Review the top ten holdings, the weight of the largest position, and whether the fund uses equal weighting or a capitalization‑weighted approach. Funds with a steep drop‑off after the top few names or with more than 10 % in a single stock warrant extra caution.

Once you understand the holdings, compare them with your existing core positions. If a thematic ETF looks nearly identical to your broad market ETF—both heavy in mega‑cap technology names—you may be taking more risk without materially altering your overall exposure.

Free ETF Data Screeners

The internet is awash with free tools that can help investors filter and compare sector and thematic ETFs. Sites like Stockanalysis.com host comprehensive ETF screeners. The stockanalysis screener covers over 4,600 funds and lets users sort by asset class, sector, performance, dividends and other factors; each result displays key data such as fund name, asset class, assets under management, price, volume and the number of holdings. Other free resources include ETFdb’s thematic lists and Yahoo Finance’s screener, which allow investors to search by keyword, sector, expense ratio, liquidity and more.

Here is a simple checklist for vetting and screening ETFs:

1. Start with the theme: Define what trend or sector you want exposure to.
2. Use a screener: Input the desired sector/theme and filter by assets, expense ratio, liquidity (average daily volume) and track record. Free tools such as Stockanalysis, ETFdb and Yahoo Finance can help with this.
3. Check the holdings: Review the top ten positions, the weighting scheme and the concentration in the largest names.
4. Assess overlap: Use an overlap tool like ETF Research Center to see how much duplication exists relative to your current portfolio.
5. Evaluate fees and liquidity: Lower fees and ample trading volume are preferable, especially for tactical allocations.

By systematically screening and vetting thematic ETFs, investors can capture megatrends while controlling risks and avoiding unnecessary duplication.