What’s a Sector-Specific Fund?

CATEGORIES: Investment Planning

Sector Investing With ETFs

There is a certain type of investor who doesn’t fancy sitting glued to a Bloomberg terminal every day but who still wants to intellectually engage with the market and make some active portfolio decisions. Sector funds might be just the right fit.

“Sector funds” offer targeted exposure to a specific sector. What’s a sector? The Dow Jones categorizes ten “supersectors”: Oil & Gas, Basic Materials, Industrials, Consumer Goods, Health Care, Consumer Services, Telecommunications, Utilities, Financials, and Technology. These supersectors broadly encompass the economy as a whole.

Within each of these supersectors are two additional levels: sectors and subsectors. Insurance, for example, is a distinct sector that falls under the “Financials” category. Property & Casualty Insurance is a subsector underneath the Insurance sector. In other words, the taxonomy is:

Financials >> Insurance >> Property & Casualty Insurance

Supersector >> Sector >> Subsector

Likewise, the Consumer Goods supersector includes the sector Personal Goods. And that sector contains the subsector Footwear.

How Risky Are Sector-Specific Funds?

The narrower your sector becomes, the more that both opportunities and risks present themselves. Factor both these opportunities and risks into your mutual fund analysis.

Certain sectors tend to outperform or underperform in different stages of a typical business cycle. As the economy heads into a recession, for example, businesses and households react by making fewer purchases and focusing their spending on those things they need the most. Companies will still buy administrative supplies because they have offices to run, but will probably order smaller volumes of raw materials, anticipating that sales volumes will decline. Households might decide to skip the weekly Friday night dinner at Applebee’s, but will still need to buy the usual quantities of soap and toothpaste.

Sector investors will try to map those types of economic habits to the sectors and companies likely to be the beneficiaries. Industries like consumer staples, defense contractors and utilities are sometimes referred to as “defensive” sectors for their tendency to do better in recessionary times, while others like consumer discretionary goods, technology and industrial materials are considered “growth” sectors as they often lead the way in the early, fast-paced stages of a recovery cycle.

The flip side to relative outperformance is the added risk that comes from concentrating your bets. By choosing to invest in a specific sector you are adding an element of business risk on top of the systematic market risk that comes from being exposed to the broader equities market. In other words, your returns are subject to more short-term volatility  than the broader market, and if your bet is mistimed, this can result in much higher-than-average losses.

Risk, in this sense, is additive: investing in a sector exposes you to the risks of that sector plus overall market risk, while investing in a single stock exposes you to that company’s unique risks plus the sector risks for its applicable industry plus the broader market risk.

Do I Want a Sector-Specific Fund?

Active or quasi-active investors may want to use sector funds as an overlay, rather than a core portfolio component. Say, for example, you have a portfolio that broadly tracks the S&P 500. You see evidence that the economy is headed towards a downturn. As a tactical move you can invest in a “peripheral overlay” position – say, a 10-15% position comprised of a “defensive” sectors like consumer staples and utilities.

By limiting your sector bet to a relatively small percentage of your total portfolio you hedge the downside risk of your assessment being wrong, but you may get some relative performance benefits if your economic assessment was right.

History Won’t Always Repeat Itself

As you analyze mutual funds, remember that history seldom repeats itself, and even time-tested sector strategies may not always work as they did in the past. There is no assurance that any given sector will react to the next business cycle the same way it did for the last ten cycles.

Then there is the issue of timing: the darling of one phase in the cycle can be the dog of the next. Financial services stocks performed spectacularly well during the middle years of the 2000s decade. If you were slow to unwind your positions when the subprime crisis hit in 2007, those outperformance gains would have been rapidly erased.

Sector investing calls for discipline, agility, and staying abreast of market developments. Make sure you are ready to make that commitment before taking the plunge into sector funds.

Learn more about which funds are right for you at Jemstep.com

This post was originally published here.

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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.


One thought on “What’s a Sector-Specific Fund?

  1. Pingback: Which ETFs Are Best for You? | The Better Investor @Jemstep

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