Going Overboard? Sector Funds Rake in Record Sums of Cash

Like small fishing boats straying too far out to sea hoping to land a big one, some mutual-fund investors are taking big risks in search of fat returns and could end up in deep, um, water.

Investors are pouring more cash than ever before into sector-focused mutual funds -- those that only invest in stocks within one industry sector, such as health care, or a thinner sliver of a sector, such as biotechnology within health care.

Here's the danger: While a focused strategy paid off in a once-in-a-blue-moon kind of year like 1999, when the average technology fund turned in a triple-digit return, the scores of investors overloading on sector funds are vulnerable to the sudden downward gusts that often visit volatile sectors. Those occasional slides are a tempest in a teacup for a diversified portfolio, but they can crush an investor too focused on one or two groups.

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"It's a loser's game," says financial planner Frank Armstrong, president of Miami-based Managed Account Services and chief investment strategist for DirectAdvice.com. "There's always going to be one sector that's better than others on a given day or year, but it's almost impossible to consistently get that right."

To be sure, the boom in sector funds has been a natural offshoot of the technological revolution that is transforming the economy, which has led to outsize performance in the stocks of companies that are fueling the transformation. Sector funds provide an easy way for investors to place a bet on an area with great potential for growth. But it's clear that some investors aren't spreading money around as much as they used to.

Let's go to the numbers: In just the first five months of this year, a whopping $44 billion has poured into the industry-focused crowd, trouncing the $29 billion tally from all of last year, which itself had been a record-setting year for sector-fund flows.

Let's go to even more stark numbers: Historically the conventional wisdom on sector funds has been that they spice up a portfolio, but shouldn't comprise more than 10% of your assets. Still it looks like some investors might be blowing right by that 10% target. From 1990 through 1998, sector funds never accounted for more than 4.8% of total flows to U.S. stock funds. But in 1999 that shot up to 19.9%, and in the first five months of this year it's up to a whopping 44.4%, according to Boston fund consultancy Financial Research, or FRC.

Before 1998, the record for calendar-year flows to sector funds in the 1990s, after redemptions, was $11.1 billion set in 1993, according to FRC. Sector funds have lapped that record more than four times in the first five months of this year, mainly due to investors' ravenous appetite for tech funds.

Sector Fund Inflows Figures are in billions of dollars.

Source: Financial Researach Corporation. YTD data through May 31.

"You're seeing more money going to sector funds because people are chasing performance," says Ron Roge, a financial adviser based in Bohemia, N.Y. "People get enamored with huge returns and it's just the thrill of the chase."

After several tech funds and other sector funds posted dazzling returns last year, investors are betting heavily on those sectors and others, even though they could be hit hard when the industries inevitably fall from favor.

Last year, the average technology fund rose a stunning 135% and the average telecommunications fund gained 70.8%, compared with a 21% gain for the S&P 500, according to Morningstar. Sector funds often show up on scorecards due to their feast-or-famine returns, but the magnitude of their outperformance led to a record-setting stream of investor dollars and an explosion of new funds focused on the tech and telecom sectors in particular.

If investors' tech fever is any indicator, it doesn't look like their hunger for sector funds will flag any time soon. Even though tech funds have had a mercurial run in 2000 and are flat for the year, a June survey of some 850 investors who buy funds on Charles Schwab's popular OneSource online fund supermarket found that 52% had bought tech fund shares in the past six months, up from 27% a year earlier. And 46% said they plan two invest in a tech fund in the second half of the year, up from 21% a year earlier.

If investors eventually tire of tech funds' doldrums, the sector could be hit inordinately hard -- consider that steep outflows from financial sector funds and value funds put significant selling pressure on financial stocks over the past two years.

"I don't think [big sector bets are] well-advised," says Armstrong, who favors broad index funds, which try to match the performance of a broad index such as the S&P 500.

A growing risk attendant to the sector-fund boom is an increase in specification, particularly among technology funds. While many have broad mandates allowing them to hold virtually any company with a Web site, including the low-tech likes of Wal-Mart and Merrill Lynch, others focus on thin slivers of the tech sector.

Investors can now invest not only in the Internet but in slices of the Net. There are funds that focus on e-commerce like(TEFQX)Firsthand e-Commerce, business-to-business e-commerce like Amerindo B2B Internet, and networking like Fidelity Networking & Infrastructure. So, these funds focus on a subsector (B2B e-commerce) within a subsector (e-commerce) within a subsector (Internet) within a sector (technology). Investors also now have a fund that focus strictly on tech companies based in India or run by Indian management teams.

Given the volatility of the waters in some once-hot sectors these days, many advisers say investors can still try to reel in the big catch on occasion, but should make sure they're also casting a broader net.

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