Sector funds: Are they right for you?

You’ve heard that market timing rarely pays, but occasionally you’d at least like the flexibility to be more tactical with your portfolio picks.

Sector funds could be the tool to use, but are they worth the risk? The answer depends on how actively you follow the market and what you already own.

“You have to ask yourself why you want to buy into that particular sector, why you believe it’s likely to outperform, and what your criteria are for getting rid of it,” says Tom Fisher, an investment adviser and financial planner with Fisher Financial Strategies in Cambridge, Mass. “If you can’t answer those questions, you probably shouldn’t own it.”

Sector funds, also called specialty funds, concentrate their equity investments in a single sector of the economy, such as energy, health care, real estate, technology, consumer staples or precious metals. You can access individual sectors by investing in mutual funds and exchange-traded funds, or ETFs. Many fund families offer one type of fund or the other — and some offer both.

Some specialty funds drill further into subsectors, such as biotechnology, while others track specific indexes, such as the Financial Select Sector SPDR ETF, which seeks to mirror the returns of Standard & Poor’s Financial Select Sector index.

Such funds enable investors to target their exposure to specific industries and economic niches that may be underrepresented in their portfolio without having to bet on individual stocks.

Tactical traders, who understand how macroeconomic events move the markets, also use sector funds to take advantage of the business cycle via sector rotation strategies.

Indeed, specialty funds have some serious upside potential, giving investors who are willing to absorb potential losses the muscle to outperform the market.

For example, Fidelity Select Biotechnology posted an eye-popping 38.8 percent annualized return over the past three years. In 2013 alone, it surged 65.66 percent.

But sector funds have also logged some dizzying falls.

According to fund tracker Morningstar, precious metals equity funds, which invest in companies that mine and process gold and other precious metals, posted a 53 percent gain in 2009 and a 42 percent jump in 2010. However, the sector has had heavy losses since then. In January 2014, precious metals equity funds were suffering from a one-year loss of almost 45 percent.

Main Street beware

In fact, due to their propensity for extremes, buy-and-hold investors should steer clear of sector funds altogether, says Christine Benz, director of personal finance for Morningstar.

“Generally speaking, I tell people to avoid them,” says Benz. “There’s added risk in betting on a single sector, and they are often redundant with what’s already in an investor’s portfolio.”

Most total market index funds, she notes, include an appropriate allocation to all sectors of the economy. Costs are another knock against them. According to Morningstar, the average expense ratio for sector funds is 1.46 percent, compared with 1.26 percent for a diversified U.S. stock fund.

“Generally speaking, you will pay more for a sector fund than an average mutual fund, although costs have come down now with the advent of exchange-traded funds that focus on single sectors,” says Benz.

Expense ratios for many sector ETFs are around 0.75 percent, but, “It’s not hard to find ETFs that cost half that,” adds Fisher.

Sector rotation strategies

Despite their drawbacks, active traders with their finger on the pulse of the economy might still decide the opportunity for reward is worth the risk. Some, for example, forgo the more traditional asset allocation strategy of diversifying across all asset classes, including stocks, bonds and commodities, in favor of a portfolio constructed entirely of funds that track selected economic sectors or industries.

They then seek to outperform their buy-and-hold counterparts by moving money from one sector fund to another based on anticipated shifts in the economic cycle, seasonal events that impact stock prices and global market momentum. To manage risk, sector rotation enthusiasts stay diversified by investing in a broad spectrum of sector funds with minimal correlation, which ensures that part of their portfolio zigs while the rest of it zags.

“Certain sectors, when taken by themselves, can be more volatile, but their volatility is also an advantage,” says Chris Gaffney, senior market strategist for EverBank Wealth Management in Jacksonville, Fla., noting noncorrelated assets make for a smoother ride. “You don’t want all your investments to react the same way to the same macroeconomic stimulus. If they all move up at the same time, the same will happen on the downside.”

That said, Gaffney believes most Main Street investors would be best served by implementing sector rotation as a component to their otherwise well-diversified portfolio of stocks, bonds and cash.

What to allocate to sector funds

The question is, what percentage of one’s portfolio should be earmarked for sector funds? Benz says 5 percent is a reasonable starting point, noting the weighting of most total stock market index funds can also serve as a guide.

“If you’re looking at a sector weighting in your portfolio that’s maybe 5 or 10 percentage points higher than the total stock market index, that’s not unreasonable,” she says. “Beyond that is too risky.”

Before they buy, investors should perform an audit of their existing portfolio, so they know what they own and where any holes exist, Benz adds.

Morningstar’s free Instant X-Ray tool allows investors to plug in the name of their holdings and the dollar value of each. The report produces an analysis of their asset allocation and exposure to different investment styles, geographic regions and sectors, compared alongside S&P 500 index weightings.

Lastly, Benz notes, it’s important to review the top holdings of any sector fund you’re considering. Many hold large positions in two or three stocks, especially the index funds, which are weighted by market capitalization, she says. A tech sector ETF, for example, might be highly concentrated in Apple, Google and Microsoft stock, which limits diversification further still.

“Not only are you betting on a single sector, but you’re betting heavily on a few companies,” says Benz. “Really do your homework on index construction and portfolio construction,” she says.

Sector funds can deliver targeted exposure to pockets of the economy and an opportunity to outperform, but their volatility and elevated cost make them poorly suited for the average individual investor.

“Most people can’t pay attention that closely to the markets,” says Fisher. “You have to know when to get rid of it, and that’s hard for a lot of investors. Emotions kick in, either panic or a psychological affection for the stocks they own, which blinds them to risk.”