An Introduction to Sector Mutual Funds

There are several different ways one can diversify a portfolio, such as the different categories of the Morningstar style box, which contain several different asset classes. But another common way to diversify is between the various sectors of the economy. This is usually accomplished with mutual funds that concentrate in one of the major sectors, such as natural resources or utilities. (See also: Choosing Quality Mutual Funds.)

This article will examine the nature and composition of sector funds and the advantages and disadvantages that they present to investors. (See also: The Industry Handbook.)

As the name implies, a sector fund is a mutual fund that invests in a specific sector of the economy, such as energy or utilities. Sector funds come in many different flavors and can vary substantially in market capitalization, investment objective (i.e. growth and/or income) and class of securities within the portfolio. Sector funds do not fall into a particular category in the Morningstar style box, such as large-cap value or mid-cap growth; instead, Morningstar ranks and analyzes sector funds in the following eight categories. (See also: Understanding the Style Box and Morningstar Lights the Way.)

1. Natural Resources Funds: These funds invest in oil and gas and other energy sources, as well as timber and forestry. These funds are usually appropriate for long-term growth investors.

2. Utility Funds: These funds invest in securities of utility companies. They are usually designed to pay steady dividends to conservative fixed-income investors, although they may have a growth element as well. (See also: Asset Allocation Within Fixed Income.)

3. Real Estate Funds: These funds provide a way for smaller investors to participate in the gains from real estate without having to actually buy real property. They often provide both growth and income. (See also: A Guide to Real Estate Derivatives.)

4. Financial Funds: These funds invest in the financial industry. Holdings will include securities of investment, insurance, banking, mortgage and accounting firms.

5. Health Care Funds: These funds can cover any kind of for-profit medical institution, such as pharmaceutical companies. Many of these funds also focus on biotechnology and the companies that make pioneering advances in this industry.

6.Technology Funds: These funds seek to provide exposure in the tech sector. This sector focuses primarily on computers, electronics and other informational technology that is used in a wide range of applications.

7. Communications Funds: These funds focus on the telecommunications sector, but can include internet-related companies as well.

8. Precious Metals Funds: These funds provide exposure to a variety of metals, such as gold, silver, platinum, palladium, and copper.

Some sector funds focus on a specific subsector of the economy, such as banking or semiconductors. Morningstar classifies these funds into larger peer groups for analytical purposes.

Investors who are considering sector funds should be prepared to accept greater risk and volatility than what they will endure in the broad-based funds and index funds. The various sectors of the U.S. economy have historically had higher highs and lower lows than the economy as a whole.

Subsectors, such as biotechnology, can be even more volatile. Sectors do perform differently at various points in the overall economic cycle. Some sectors do well in bull markets but poorly in bear markets, while others can grow earnings even during sluggish periods and recessions. Sector funds also tend to have higher turnover than other types of funds, so tax-conscious investors should pay close attention to capital gains distribution rates. (See also: A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)

Sector funds are designed to provide market participation for investors whose portfolios lack exposure in a given sector. They can also provide a greater measure of diversification within a given sector than may be otherwise possible. The main reason that an investor would want to consider a sector fund is the same as for a particular individual stock: The investor feels that the sector is about to experience a period of strong growth.

Instead of investing directly in the stock of a company that has just released a revolutionary new technology, the investor could consider allocating assets to a technology fund that holds that company's stock in its portfolio. Sector funds can also serve to hedge a portfolio, as some sectors tend to move opposite the economy as a whole. For example, high energy prices can be a drain on the rest of the economy but a boon to the energy companies themselves. Investors seeking to profit from this condition would benefit from investing a small portion of their portfolios in an energy fund. (See also: Asset Allocation Strategies.)

Important thresholds for any investor considering focused sector bets is to own a diversified mainstream portfolio. In order to diversify efficiently, planners should carefully examine possible overlap between any potential sector fund and the client's current portfolio, so that any sector fund that is chosen contains the fewest possible stocks that are already held outright or held in another fund.

Many of the security holdings within a sector fund are also often found in the mainstream funds of that fund family. For example, major oil stocks, such as ExxonMobil are likely to be found not only in a given fund company's energy sector fund but its flagship large-cap value fund as well. Therefore, sector funds that invest in a specific subsector, such as alternative energy sources, may provide greater diversification than a broader-based fund in some cases.

Investors who add sector funds to their portfolios should also be aware that timing specific sectors of the market can be riskier and more difficult than trying to time the market as a whole. As mentioned previously, subsector funds are even more volatile by nature than broader-based funds, as their narrower focus will render them even more vulnerable to the economic cycles that can affect a specific industry, such as banking or mortgages.

Morningstar recommends that investors limit their exposure to any given sector to 5% of their portfolio. The use of such asset and sector allocation strategies as dollar-cost averaging or periodic portfolio rebalancing is also highly recommended. These methods can effectively reduce the volatility inherent in sector funds. However, sector funds tend to be appropriate for more aggressive investors seeking higher returns over time.

Perhaps most importantly, sector fund investors should be prepared to stay invested for at least 5-10 years, so that they can experience the entire cyclical rise and fall of the sector. Investors with time frames shorter than five years face substantial market risks.

Sector fund investors should closely monitor what they pay in terms of sales charges and annual expenses for sector funds, which run higher than funds in more general categories. This is because sector funds (in any category) lack the asset base that is found in mainstream funds, such as a flagship growth or income funds. As a result, they do not enjoy the subsequent economic scale pricing that larger funds can offer.

Investors who are participating in market-timing strategies would be wise to explore the world of sector spiders and exchange-traded funds (ETFs) that are available. These provide similar diversification to mutual funds but trade like stocks and can be purchased much more cheaply than traditional open-end funds. Many of these can also be shorted for those investors who use short sales as part of an overall hedging or investing strategy. (See also: What Is a Spider and Why Should I Buy One?)

Sector funds are appropriate for aggressive investors seeking exposure within either an entire sector of the economy or a specific subsection thereof. Overexposure to any given sector of the market can subject investors to undue risk and volatility, and appropriate measures should be taken to avoid this.