Sector funds target specific industries and economic niches to seek above-average returns. With the opportunity for greater returns comes greater risk, as these funds typically are prone to fluctuate in value more than diversified, multisector funds.
Sector funds may invest solely in specific industries, such as utilities, technology, financial services, health care and manufacturing. They may also invest in commodities, such as oil and gold. Additionally, there are sector funds that invest in specific international markets, such as Germany and China.
Many investors look to sector funds or exchange-traded funds to gain exposure to industries that may appear to offer exceptional potential. Top-down investors and market timers look first for industries that often perform well in certain economic cycles and then seek to predict which industry will be next in the “rotation.”
Because of their higher potential volatility, it may be prudent to limit investments in individual sectors to no more than 10 percent of an overall equity portfolio.
Another important use of sector funds is to choose a sector that you want to be overweight relative to the S&P 500 benchmark. Because many investors judge performance relative to this market benchmark, it is important to understand how your portfolio holdings match up to the S&P. Relative performance can often be explained by your sector weightings. For instance, year-to-date performance of health care is 27 percent compared with 7.5 percent on the materials sector. If you are overweight health care and underweight materials, chances are you are beating the market.
Some investors choose a contrarian strategy, seeking value in sectors that have been passed over by the rest of the market. Another strategy is the tilted index. Passive investors will invest in a market index seeking to avoid the inefficiencies of picking individual stocks. By adding shares of sector funds that outperform the market, you may outperform the index overall.
Evaluating sector funds
Whatever strategy you use in choosing a sector fund, be careful not to chase past returns. A high-flying sector may be at its peak. It’s rare for one sector to lead the pack year after year.
For the past five years, the top three peforming sectors from the S&P 500 were:
• 2009: Information technology, materials, consumer discretionary
• 2010: Consumer discretionary, industrials, materials
• 2011: Telecommunications, utilities, health care
• 2012: Financials, consumer discretionary, telecommunications
• 2013: Health care, financials, consumer discretionary
You also should be aware that even if the name of the fund is the same, not all sector funds are alike. Stock/cash allocations, sector segment weights, top holdings, portfolio size, past performance, yield and portfolio turnover are among the criteria used to compare funds that invest in the same sector.
• Stock/cash allocations refer to the percentage of a fund’s assets that is actually invested in the chosen sector. In addition to cash, funds may invest in bonds, or even stocks from other sectors. Although these investments may increase performance or decrease risk, you should be aware of the portfolio’s composition.
• Many sectors can be divided into subsectors and industries, and sector weight refers to the percentage of assets invested in each.
• Portfolio turnover measures trading aggressiveness and often exceeds 100 percent in a single year.
• Although past performance is no guarantee of future results, the longer the return period the better. Look at returns over at least a five-year period, if available. Investors should ideally compare how funds performed in a variety of different market climates and be prepared for the volatility inherent in many sector funds.
• Yield is just one component of total return, but high yield can mean less reliance on capital gains. This often points to lower volatility.
As with any investment, be sure to get a copy of the fund’s annual report and prospectus before investing. You also should consult with your financial professional to help determine the suitability of sector funds in your overall portfolio.
• Timothy J. Dooley, CFP®, is president of Comprehensive Retirement Resources, Inc., an independent firm located at 201 N. Draper Road, McHenry. His number is 815-578-4217. Tim specializes in retirement and estate planning. He offers securities through Raymond James Financial Services Inc., member FINRA/SIPC. Views expressed are those of the author and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Be sure to contact a qualified professional regarding your particular situation before making any investment or withdrawal decision. You should discuss any tax or legal matters with the appropriate professional.