John J. Diak, CFP®
Consider Sector Funds for Targeted Diversification
Traditionally, one of the cornerstones of mutual fund investing has been risk reduction through diversification. By purchasing shares in a variety of companies, mutual funds can reduce long-term volatility, or market risk. Thus, a well-rounded mutual fund portfolio may include a number of different types of mutual funds, and sector funds are no exception.(1)
Sector funds target specific industries and economic niches to seek above-average returns. Although these funds may reduce individual security risk, some may fluctuate in value more than diversified, multisector funds.
Variety of Sectors
Sector funds may invest in oil, gold, utilities, financial services, technology, or health care, to name a few. Sector funds may also include a greater percentage of small-cap stocks, which may offer greater opportunity for growth but at the expense of potentially greater risk.
There are also sector funds available that invest in selected international markets. Sector funds that invest in Europe or Latin America offer an opportunity to diversify and possibly reduce your overall risk. Even if risks are higher than those for a domestic fund, if the foreign markets are not highly correlated with the U.S., your overall risk may be reduced. In general, however, foreign sector funds are more risky than global or international funds diversified among many countries.
Here's a quick look at some of the more prominent sectors in today's financial marketplace.
Utilities -- Utility funds are the most common sector funds and have often appealed to investors seeking income and growth. In the past, the prices charged by water, gas, and electric utilities were set by government agencies. These prices included a profit for the utilities, which was passed along to investors in the form of dividends. Deregulation has swept across many utilities industries, creating more risk and perhaps the potential for higher returns as well.
Source: ChartSource®, DST Systems, Inc. Sector performance is represented by the 10 GICS sectors of the S&P 500 index. Past performance is not a guarantee of future returns. Copyright © 2016, DST Systems, Inc. All rights reserved. Not responsible for any errors or omissions.(CS000172)
Regulatory issues aside, utilities have generally been a stable industry that was once dominated by electric companies. However, increasing deregulation in the gas, electric, and telecommunications fields has added a bit more volatility to these stocks, although dividend yields remain comparatively high. Utility stocks also may be susceptible to interest rate fluctuations since most of their income is still derived from their dividend yields.
Technology -- Another popular sector is high technology. These funds tend to focus on industries such as computer software and semiconductors. Since it tends to be populated by growth stocks, the high-tech sector typically has higher potential returns and low or no dividend yields. This combination causes this sector to be highly volatile and cyclical. It is not unusual to see high-tech funds move from the top to the bottom of fund return rankings over relatively short periods of time
. Health Care -- The explosive growth of the health care industry has not gone unnoticed. Health science funds have proliferated and have outperformed the market on average over the past decade. These funds are also highly cyclical and susceptible to government regulation. As with high-tech funds, investors trade volatility for the potential of high returns.
The Role of Sector Funds in a Portfolio Sector funds may be used to seek exposure to industries that 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% of an overall equity portfolio.
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. And even if the name 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 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% in a single year.
Although past performance is no guarantee of future earnings, 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.
Answers to investors' questions about a particular fund are available from a variety of sources. Be sure to get a copy of the fund's annual report and prospectus. Firms such as Standard & Poor's, Morningstar, and Value Line publish fund performance statistics and rankings. Look for industry weightings, top holdings, expense ratios, yield, and total return. And be prepared to ask your financial advisor questions about the suitability of sector funds in your overall portfolio.
1 Diversification does not ensure against loss.
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