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Course 405
Sector-Fund Investing

Introduction

Everyone knows you can start a fire using a magnifying glass: Grade school kids routinely put this optics lesson to the test. This experiment teaches a valuable lesson: Focus is a powerful thing.

The power of focusing is the principle behind sector funds, mutual funds that invest in a specific industry. How powerful can sector investing be? At the end of 1999, nine of the 10 funds with the best 10-year returns were technology funds.

Such stellar returns are often the reason investors flock to particular sectors, such as technology during 1999 or financials in the mid-1990s. More recently, at the end of 2007, natural resources and real estate funds led the charts with top-tier 10-year records.

While sector investing offers great potential, it offers great risk, too. We all know what happened to technology and real estate after their runups, and even commodities swooned during the 2008 downturn. How much more volatile can these funds be? The standard deviation (the variation of a fund's monthly returns around its average monthly return) of the average technology fund is almost double the S&P 500's.

In this lesson, we'll discuss the variety of sector funds available, ways you might-or might not-use them in a portfolio, and what to look for when buying a sector fund.

The Many Flavors of Sector-Fund Investing

Investors have many sector funds to choose from, spanning eight different Morningstar categories: communications, consumer discretionary, consumer staples, equity energy, financials, health care, industrials, natural resources, precious metals, real estate, technology, and utilities. Some sector funds focus more narrowly, homing in on a particular subsector of an industry. For example, Fidelity Select Biotechnology (FBIOX) is categorized as a health-care fund, but it invests in just biotech companies, which tend to have very different characteristics from medical suppliers and diversified pharma firms. Likewise, Fidelity Select Wireless (FWRLX) is a telecom fund that focuses entirely on wireless service providers and gearmakers. Given their more concentrated focus, these funds could be even more volatile than the typical sector fund.

Do You Need a Sector Fund?

Not according to John Bogle, the founder of Vanguard funds and the granddaddy of index investing, who is firm: "You could go your entire life without ever owning a sector fund and probably never miss it." (But despite this, Vanguard offers sector funds such as Vanguard Health Care (VGHCX) and Vanguard Energy VGENX.) Bogle's point is simply that a well-diversified portfolio doesn't need sector funds.

Let's take an example. If you owned Vanguard Total Stock Market Index (VTSMX), you'd have all of the major U.S. industries covered. The fund's portfolio would range from nearly 2.8% in real estate stocks to about 16.7% in technology as of March 31, 2011. Your other significant exposure would be almost 13.6% in financials and 13.5% in industrials. That's pretty broad diversification, so you might not need or want to invest additionally in a sector fund-especially not one focused on bank stocks or tech firms, or anything else significantly represented in the index.

Using Sector Funds to Diversify

This is the bringing-coals-to-Newcastle rule: If a sector is already well represented in your portfolio, why buy more of it? If you're going to make use of a sector fund, it should add something your portfolio lacks, or it should increase your exposure to a sector that is underrepresented in your portfolio.

To determine whether you should buy more funds in a particular sector, you need to know and monitor your portfolio's sector weightings. Vanguard Total Stock Market, for example, owns only 3.18% in utilities as of March 31. More conservative investors who like the dividends that utilities stocks often pay out might want to right bump up their exposure with a utilities sector fund.

Speculating with Sector Funds

It can be so tempting to dive into a part of the market that you think will soar based on some trend, an analyst's recommendation, or your gut. Morningstar isn't a fan of this kind of speculation, but if you must, do it sensibly. Reserve a very small slice of your portfolio-say 5% or less-for such activities and make sure the remainder of your portfolio is well-diversified and designed to meet your long-term investment goals with a level of risk that is acceptable to you. Finally, understand that when you speculate, you may be wrong-in other words, be prepared to lose that 5% of your portfolio.

We also recommend that you avoid buying a fund that's already hot. Investors who fall prey to that temptation often miss out on some great returns from underappreciated funds. If a fund is hot enough to catch investors' attention, many of its holdings may sport tremendously high price multiples. Investors chasing such hot funds can wind up losing money when the companies they hold fail to live up to the lofty expectations embedded in their prices.

Take T. Rowe Price Media & Telecom (PRMTX), a topnotch sector fund. The offering boasted fantastic returns when the communications frenzy took hold in the late 1990s, posting a 93% gain in 1999. Investors loved the sector and they hopped on board just in time to spend the next three years in the red. It's worth pointing out, of course, that the fund continues to impress-at least on a relative basis. It may lose a lot of money from time to time (such as 2008, when the fund lost 46% compared with the S&P 500's 37% decline), but it generally outpaces its industry rivals nicely, and is at the top of its category over the trailing 5- and 10-year period.

If you can't resist the temptation to bet on a sector, though, do one of two things: Either play long-term trends (the aging of the baby boomers and increased demand for health care is one such trend) and dollar-cost average (invest a set dollar amount each month) into your sector fund, or make a bet on an out-of-favor sector, particularly one that most other fund investors are avoiding. Because the average investor doesn't have such good timing, you can often outperform by buying what most investors are selling. We'll explore this strategy in a later lesson.

A Few More Questions

In addition to the questions you would ask about performance, risk, portfolio holdings, management, and costs before buying any fund, ask two more questions that apply specifically to sector funds:

How diversified is it?

As we explored earlier, some sector funds are quite concentrated. It's therefore important to know if the fund favors certain subsectors and totally disregards others.

To get some idea of a fund's diversification, you can check its weightings, holdings, and concentration (how much of its assets it has in its top 10 holdings) in the portfolio section of its fund report page on Morningstar.com In addition, you should examine the fund's shareholder report and read its prospectus.

Does it charge a redemption fee?

Sector funds very often charge redemption fees if you sell the fund within a certain period of time from purchase. Redemption-fee information appears in the expenses section of our fund reports.

As a long-term investor, you shouldn't get hung up on redemption fees, though. In fact, think of them as your friends. The fees penalize people who invest for less than a set period of time (often three months, but sometimes a year or more). Basically, they are penalties for early withdrawal that are paid back into the fund rather than to the fund company. Funds use these fees to deter investors who rush into hot funds, then flee when they turn cold. These shareholders can undermine a fund's performance with untimely buying and selling.

Quiz 405
There is only one correct answer to each question.

1 Which statement is false?
a. All investors need sector funds.
b. You can use sector funds to diversify a portfolio.
c. You can use sector funds to speculate on a particular industry.
2 Which sector-fund strategy should you avoid?
a. Buying sector funds representing areas of the market in which you are currently underweighted.
b. Buying sector funds that are performing exceptionally well.
c. Buying sector funds that are unpopular with mutual fund investors.
3 What costs are actually good for long-term sector-fund investors?
a. Annual expenses.
b. Sales charges or loads.
c. Redemption fees.
4 Which type of fund is bound to be most volatile?
a. A fund investing only in Internet stocks.
b. A fund investing in technology stocks, including Internet stocks.
c. A fund investing in technology and nontechnology stocks.
5 If you're investing in a long-term trend, such as buying a health-care fund to play the Aging of America theme, which should you not do?
a. Sell the fund if it loses money in a calendar year.
b. Dollar-cost average into the fund.
c. Buy when the sector is out of favor for a short-term reason.
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