In this part of the series, we’ll study the risks associated with investing in the Financial Select Sector SPDR ETF (XLF).
As with investing in equity, the stocks in XLF will change in value. An investor can either gain or lose on investments according to stock market movements. Apart from this, investing in XLF has other risks.
XLF is managed passively and attempts to track the performance of an index of securities. An actively managed fund attempts to outperform the index. Thus, an actively managed fund picks securities in the index without concentrating on any particular industry or sector.
In contrast, a passively managed fund continues to hold securities of a particular sector regardless of market conditions. Thus, returns from a passively managed fund could be lower than those from an actively managed fund.
Index tracking risk
XLF aims to track the performance of the S&P Financial Select Sector Index as closely as possible. This means the fund manager attempts to achieve a high degree of correlation with the index.
However, after taking into consideration factors such as operating expenses, transaction costs, cash flows, and regulatory requirements, the fund’s return may vary from that of the index.
Sector concentration risk
XLF’s investments are concentrated in securities in the financial sector such as JPMorgan (JPM), Wells Fargo (WFC), Bank of New York Mellon (BK), and Bank of America (BAC). As such, it may be considered undiversified and will thus be more affected by downturns in the financial sector than a well-diversified fund.
The financial sector is highly regulated and very volatile. The fund’s returns, as such, also face these risks.