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Are Sector Funds a Good Idea?

This year some sector of the stock market will outperform the market as a whole. Will it be industrials? Technology? You can find lots of predictions, but nobody who knows.

Sector funds are mutual funds or exchange-traded funds that concentrate on specific industries, or “sectors,” within the broad market. Some of the more popular funds focus on technology and health care, but there is a sector fund out there for most segments of the broad market.

Fans of sector funds gamble on good timing and hunches, hoping to hit a home run and score a quick bundle.

At any given time, certain sectors are going to outperform the market and others will underperform. If you could know in advance which sector was going to “win,” you could place your bet there—just as you could win the lottery if you knew which six numbers were going to come up before the little balls were drawn. Sector funds are sold primarily to investors who are convinced that they can guess which sectors of the economy will grow fastest, and profit in the stock market from that insight.

The problem is that this is a fallacy. Over the long term, nobody can consistently predict which industry, as a group, is going to outperform the broad stock market, even if trends in the economy are apparent. This is because the outlook for each sector of the economy has already been priced into the stock market. Stocks in sectors that are expected to grow fastest are usually priced highest, bringing the expected return on those stocks back toward the rest of the pack.

For example, suppose you believe the health care industry is poised for exceptional future growth because of the aging U.S. population and the increasing need for medications, medical supplies and preventive care. You are not alone in assuming that you might cash in big by getting in early. The truth is that the market as a whole is smarter than any individual within it, and the market, therefore, has already priced these future expectations into health care stocks.

Health care stocks’ current valuations reflect this premium for expected above-average growth. Consider the average P/E ratio—a company’s current share price divided by its trailing-12-months earnings-per-share—of the Morningstar health care category. As of April 30, the P/E ratio for health care was 39.7, while the S&P 500 Index’s was 31.9. Does this mean that health care equities are overvalued? Not necessarily, because high-growth equities usually trade at higher P/E multiples as investors are willing to pay a higher price for that growth. Only time will tell if these higher valuations are warranted.

Assuming sector-specific risk can be costly. Over-weighting your portfolio in any one area means you are under-weighting it somewhere else. If your hunch doesn’t pan out, there’s the chance that the sector you’ve over-weighted may tank, or that the one you have under-weighted will produce the best returns, causing your portfolio to lag the market.

At Palisades Hudson Asset Management, Inc., we generally do not advise our clients to swing for that sector fund home run. This is hardly a surprise, since we think the chances of succeeding are poor. Our clients prefer to hold more diversified portfolios that stand a greater chance of at least matching the market’s returns. On a risk-adjusted basis, this diversification tends to outperform sector fund investments.

Part of our diversified strategy is to hold small, permanent allocations to real estate and natural resources stocks, and we often make these investments through sector funds. We consider those investments to be separate asset classes, not merely sectors of the broad stock market, because these investments are a proxy for the underlying real estate and natural resources “hard assets.” In this situation, we are able to use sector-specific funds, sparingly, to mitigate risk, because real estate and natural resources investments have very low correlations to the U.S. equity markets and also provide a hedge against inflation.

Besides the sector risk discussed above, sector funds usually introduce a considerable degree of company-specific risk. Sector funds are less diversified than more broadly focused mutual funds. The average sector fund in Morningstar’s database has 56 holdings, compared to 217 holdings in the the average large-cap blend fund. Index funds generally have even more holdings.

Funds that hold concentrated positions in a small number of stocks do not offer as much protection from company-specific risk, which is one of the primary goals of a long-term asset allocation strategy. Exposing your portfolio to unnecessary company-specific risk can allow the failure of one particular company to drag down your portfolio’s return. As Enron demonstrated, even the largest and seemingly most successful companies do not warrant over-allocations, and everyone now knows—or should know—why taking on company-specific risk is dangerous.

Cost is yet another drawback of sector funds. The average sector fund in Morningstar’s database has an expense ratio of 1.68%. In sharp contrast, the Vanguard 500 Index fund carries an expense ratio of 0.18%, a substantial 150 basis points lower. The average sector fund manager has to consistently outperform the benchmark by 1.5 percentage points per year, just to break even after expenses.

Figure 1 presents the 10-year average annual returns and standard deviations for the Morningstar specialty-sector category averages and the S&P 500. The chart illustrates the power of a steady diversified approach. We see that the Standard and Poor’s 500 Index has neither the highest average annual return, nor the lowest risk (represented by standard deviation). However, the right-most column presents a measure of risk-adjusted return, dividing the 10-year return by the 10-year standard deviation to determine how much return-per-unit-risk the investment has provided. On a risk-adjusted basis, the broad market, represented by the S&P 500 Index, outperformed all the other sectors with the exception of financials over the 10-year period through April 30, 2002.

In certain situations, such as our use of natural resources and real estate sector funds, a small allocation may be appropriate to fill holes in your diversified portfolio. But overall, sector funds, especially aggressive concentrated funds such as health care funds and technology funds, are not appropriate for investors with long time horizons who want to maintain a steady course.

Figure 1:

Risk Adjusted Return

Calculations based on data compiled through April 30, 2002

Specialty-sector Category10-Yr Return10-Yr RiskReturn/Risk
M* Cat: Specialty Financial17.32%21.28%0.81
S&P 500 Index12.22%15.92%0.77
M* Cat: Specialty Real Estate11.11%14.48%0.77
M* Cat: Specialty Health10.83%16.14%0.67
M* Cat: Specialty Utilities14.16%22.53%0.63
M* Cat: Specialty Technology10.32%24.50%0.42
M* Cat: Specialty Natural Resources10.19%25.85%0.39
M* Cat: Specialty Communications13.63%38.33%0.36
M* Cat: Specialty Precious Metals1.79%34.91%0.05




Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, is the author of several chapters in our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 11, "Social Security And Medicare"; Chapter 18, "Philanthropy"; and Chapter 19, "A Second Act: Starting A New Venture." He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.