Choosing the Best Industry ETFs

Here are 7 Morgan Stanley picks worth a look.

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These days, perusing the selection of exchange-traded funds that cover the same industry seems like shopping for olive oil at Whole Foods: There are endless brands and variations on the same core product. The choices can be overwhelming: Should you bet on the iShares oil and gas ETF or go with the PowerShares version? There's also an SPDR fund to consider.

As of May 1, there were 107 industry-specific ETFs providing exposure to more than 30 different industries, according to a Morgan Stanley report released this week. By design, industry-specific ETFs allow investors to own a basket of stocks in a given slice of the economy. "It's a low-risk way to play an industry you might like," says Paul Mazzilli, Morgan Stanley's director of ETF research. "Instead of betting on one name, you can bet on, say, 20-something names."

But investors shouldn't choose blindly among ETFs representing the same sector. Here are a few tips on choosing an industry ETF, along with seven recommendations from Morgan Stanley:

Look under the hood. Initially, two ETFs may appear to be similar by name, but the formulas behind their underlying indexes can result in very different portfolios. Most ETFs are weighted by market capitalization, which means larger companies receive greater representation in the index. But in an equally weighted fund, all stocks carry the same weight, regardless of a company's size, earnings, or revenues (so you'll find more small companies in equally weighted ETFs). "The major difference is really your exposure to larger-cap names or smaller-cap names, but the results can be curious," Mazzilli says.

Here's an example of how this plays out. In its report, Morgan Stanley examined two retail ETFs: the equally weighted SPDR S&P Retail ETF (symbol XRT), which includes 53 companies, and the Retail HOLDRs Trust (symbol RTH), which has no underlying index and holds just 18 stocks.

Because the S&P fund includes more small companies, it's heavily exposed to apparel—a more cyclical slice of the industry, Mazzilli points out. Companies with market capitalizations of under $5 billion make up 60 percent of the fund, versus just 7 percent in the HOLDRs fund. In that ETF, retail giants Wal-Mart, Home Depot, Target, and Walgreens account for half of the portfolio.

Find the best fit. There is no right or wrong way to invest in an industry. For example, some investors may favor an alternative-energy ETF that invests globally, since many of the prominent solar and wind companies are overseas. Investors who want exposure to lesser-known names may want to be in an equally weighted index. "Investing in industry ETFs reminds us of the late 1970s/early '80s sitcom Diff'rent Strokes," according to the Morgan Stanley report. "We believe that once investors have determined the type of exposure they are seeking, the ETF that provides the best fit is generally evident," the report says.

When in doubt, lean toward large companies. Mazzilli currently favors ETFs that weight holdings based on market capitalization, which leads to more large-company holdings. "Right now, we like larger-cap names in general, and this gives you exposure to more names you know," he says.

In the report, Mazzilli and his team evaluated 45 ETFs spread out among 14 industries, ranging from semiconductors to pharmaceuticals. They highlighted the following seven ETFs that provide large-company exposure to industries currently rated "attractive" by Morgan Stanley:

• iShares DJ US Oil Equipment & Services (IEZ): holds 55 companies in the Dow Jones Wilshire 2500 Index that are suppliers of equipment or services to oil-field and offshore platform companies.

• iShares DJ US Oil & Gas Exploration & Production (IEO): made up of 63 companies in the Dow Jones Wilshire 2500 Index that are classified as exploration and production companies. The fund excludes megacap companies Exxon Mobil, ConocoPhillips, and Chevron.

• iShares DJ Aerospace & Defense (ITA): includes 36 companies in the Dow Jones Wilshire 2500 Index that are manufacturers and distributors of aircraft and aircraft parts, military aircraft, radar equipment, and weapons.