Has your investment life lost its spark? Your mutual funds don’t thrill you the way they did when your portfolio was young and anything seemed possible?
If you seek stock-market excitement, the thrill of making a bet on which business will boom over the next several months or years, it may be time to consider sector funds. These funds focus on a single sector within the stock market: technology, health care, utilities, for instance. Their concentrated power can juice your returns.
But before buying, keep in mind that the excitement cuts both ways.
If you had decided three years ago that technology was about to take off and put $10,000 into Northern Technology Fund, the best performer over that period, you would have about $33,100 today. But had the gold bug bitten and you instead bought Bull and Bear Gold Investors Fund, your $10,000 would have shrunken to about $2,500.
And getting the sector right doesn’t guarantee profits. If you had bought Monterey Murphy Technology in 1996, you would have lost 9 percent of your money over the last three years, mostly because of the fund’s heavy emphasis on biotechnology instead of computer stocks.
“If you know what you’re doing and you’re willing to accept the volatility, sector funds are all right,” said Michael Lipper, head of fund-tracker Lipper Analytical Services. “If you are willing to hold science and technology funds through some periods that were pretty nasty, for example, you’ll be all right.”
Sector funds’ nasty periods make human nature a real risk for people who buy them. Some investors just cannot stomach the ups and downs of sectors such as technology, where the value of portfolios can shrink or swell by 10 percent or more in just a few days.
“You have to recognize that you’re participating in very concentrated instruments that will definitely tell you on a daily basis how wise or unwise your choices are,” said Jim Lowell, editor of the Fidelity Investor newsletter, an independent publication that tracks Fidelity funds.
The volatility may help explain why only 5 percent of the $2.6 trillion invested in mutual funds is in sector funds, Lipper said. About 570 mutual funds, roughly 5 percent of the total, are sector funds, according to Chicago fund researcher Morningstar Inc.
Not all of them are volatile, Lowell said. Utility funds, as long as they do not concentrate heavily on the telecommunications industry, often yield steady returns with plenty of dividend income. Fidelity Select Food and Agriculture, which buys consumer stocks such as McDonald’s and Sara Lee, also is a solid hitter in all kinds of markets, Lowell said, because people buy food whether the Dow is at 5,000, 10,000 or 15,000.
Generally, though, sector funds move up and down more than the market. On April 19, the worst day for technology stocks in recent history, the average tech fund lost about 7 percent, compared with 2.24 percent for the Standard & Poor’s 500 index of stocks.
Slowly, the concept of indexing–buying a basket of the same group of stocks chosen to represent a certain sector or portion of the market–is spreading to sector funds.
There are no index sector funds, but Standard & Poor’s has Depositary Receipts that track various sectors, and Nasdaq just introduced its Nasdaq-100 shares, which track the index of the largest and most actively traded Nasdaq companies. Both the Depositary Receipts and Nasdaq-100 shares are available through brokers.
The outsized returns of some sector funds can create perverse incentives for their managers. A study by Financial Research Corp. of Boston found that customers consider only one-year performance, not a longer time frame, when looking to buy tech funds.
“This puts fund companies in the position of needing to shoot the lights out in terms of performance to generate significant flows into their technology funds, and may be the impetus for some firms to take larger than normal risks in managing their tech portfolios,” the report said.
Most experts recommend that investors consider the longer-term record of funds and be prepared to hold their investments for as long as they like the sector’s long-term prospects. They also recommend paying close attention to whether a manager is diversifying risk by investing broadly in a sector. And don’t chase performance.
“Chasing performance, as many investors are doing with tech funds, can result in taking significant short-term losses,” said Michael Evans of Financial Research Corp. “In addition, an investor should make sure a non-diversified fund is not overweighted in one security, which was the case with the Internet Fund earlier in the year. These funds are inherently riskier than a diversified mutual fund, and if a fund holds extremely large positions, the risks increase.”
The Internet Fund, 1998’s top-performing mutual fund, earned 196 percent last year, thanks in part to big bets on such Internet companies as CMGI and Yahoo.
The technology, telecommunications and natural resources sectors top most analysts’ lists right now–technology and telecom for their strong growth prospects and natural resources because of the rebound in oil prices.
Even so, not all experts agree about those sectors’ prospects. Some fear that the Year 2000 problem, which has forced many companies and individuals to buy new computers now to make sure the equipment can handle the forthcoming date change, will slow technology spending in the second half of the year, hurting those stocks. Technology stocks also have experienced outsized returns that some think cannot continue.
George Gilbert, co-manager of Northern Technology, said he believed in his sector’s long-term prospects but thought it might take a breather.
“We have a strong belief in investing in tech because it’s such a strong growth area,” he said. “Information technology as a share of U.S. gross domestic product was around 5 percent, up from 1 percent in 1990, a dramatic increase. Would I expect it to continue at the same pace? That might be stretching a little bit.”
Investment experts liken the healthy prospects of the tech sector to those of the health-care industry. The aging of the American population, combined with pressure to keep health costs down by prescribing pills instead of more expensive treatments, should generate strong returns for drug companies, Lowell said.
That sector’s returns have been so strong lately–Vanguard closed its health-care fund in March because its 1998 return of 41 percent generated a swell of new money–that Lowell thinks it may slow down for a while. He sold his shares of Fidelity Select Health Care recently to take profits. But the sector likely will provide above-average returns for investors willing to stay in for more than five years, he said.
Many individual investors may not realize that if their portfolio includes equity growth funds, they already have exposure to sector stocks. Many fund managers already have loaded up on technology, telecommunications and health care to boost returns.
Morningstar identified about 100 funds that do not label themselves as tech funds but have stakes of 40 percent or more in that sector. Many are household names such as Brandywine, Janus Twenty and Fidelity OTC.
Investors who do their homework can benefit from sector funds. They give investors diversification within a specific industry that would be tough to achieve in any but the largest portfolios, said David Giunta, senior vice president for retail marketing at Fidelity Investments, which offers more sector funds–39–than any other fund company. Diversification means investors don’t tie their fortunes to a single company.
Jack Brod, principal in Vanguard’s personal finance group, advises investors not to make big bets on a single sector. Instead, they should use sector funds to round out a well-diversified portfolio.
The amount devoted to a single sector depends on many factors, including an investor’s goals and expertise. Generally, though, it is wise to keep sector funds to less than 10 percent of your total stock portfolio, Brod said.
He also advises investors not to trade in and out of sector funds based on a few days of performance, which can rack up costly fees and destroy a portfolio.
“Unfortunately, many sector funds are used by people who attempt to time certain sectors of the markets,” said Brod. “Given the difficulty of predicting in advance which sectors are going to outperform, that leads to results that could have been better had they been in a broadly diversified fund.”
