Sector Funds: More Than Meets The Eye

Believe that a part of the economy will be particularly strong or a part of the stock market is undervalued?

Sector mutual funds are one way of investing in market niches. Sector funds enable you to pinpoint your investments in areas such as health care, biotech, and technology (or financials, after the Fed rate cut).

ETFs are another, but have some additional risks. The common cautionary note about sector funds is they're just that: an investment concentrated in one area, where all the companies share similar characteristics and react to macroeconomic or industry events in the same way.

Thus, sector funds offer only limited diversification - within a group but a group where all the stocks will move in the same direction, for the same reason.

Sector funds offer the advantage of professional management. The portfolio manager should be able to pick the best stocks in the sector. They are a sound way for an investor to participate in sectors where they wish to invest a small portion of their assets but don't want the risk of having to select a single stock - avoiding the needle in the haystack theory.

The hidden risk of sector funds, or more than meets the eye, is that mutual funds in the same sector may have very different investment philosophies and/or definitions of what comprises suitable investments. To illustrate this point, let's look at two top ten funds, according to Morningstar, from the Utility and the Natural Resource sectors.

The JHT Utilities Trust (JEUTX) and the Fidelity Select Utilities Growth fund (FSUTX) are both top ten ranked utility funds but they're different. JHT defines utilities to include telephone companies, such as A&T, and has a foreign stock among its ten largest holdings. The Fidelity fund is focused on power generation and delivery companies.

The two funds only have three stocks in common among their ten largest holdings. The same is true for the Blackrock Global Resources fund (SGLSX) and the Vanguard Energy fund (VGELX).

Blackrock's top holdings are focused on exploration, drilling and coal. Vanguard owns more of the traditional large integrated oil companies. They have no stocks in common among their top ten holdings.

Neither strategy in our examples of top performing utility and natural resource funds is right or wrong, they're just different. That's the point.

Before investing in any sector fund (or any mutual fund), review its stated investment objectives and its top holdings. Then you'll really understand the nature of the fund and if it's the right fund for you.

Sector funds have their place in your portfolio, not as core holdings, but as a diversified way of making targeted investments in selected niches. Lastly, don't forget sector funds carry more risk than broadly diversified (investing across many sectors) mutual funds.

Bill Byrnes is co-founder of MUTUALdecision, top mutual fundsa, providing investors with data on the top mutual funds, and author of the MUTUALdecision Blog. He's been CEO, chairman and served on the board of directors of several public and private companies. He holds MBA and JD degrees and is a Chartered Financial Analyst with over 30 years experience in the investment industry.