Avoid the Temptation to Play the Rotation Game With Sector Funds

There's good reason that the concept of buy and hold exists: Buy and sell and buy and sell typically doesn't work.

With so many sector mutual funds out there these days, you may be tempted to bet on the cycles of these industries. But the truth is: Rotating from sector to sector, whether via funds or individual stocks, just doesn't work for most people.

Many sectors do rise and fall according to business or economic cycles. Maybe you think you can catch the cycle of one sector, ride it up, get out at the top and then move on to another sector that's just starting to take off.

Alas, perfectly riding these vacillations is a perilous and costly undertaking. First, you must be willing to buy into an industry when it's unloved -- calling the bottom (or at least very close to it) on the way in and calling the top (or close to it) on the way out. If you can do this eight times out of 10, there's a seven-figure job awaiting you at every fund company in the country.

Second of all, you're probably going to rack up some hefty costs -- in the form of redemption fees (which many funds install to deter rapid moves in and out of funds) or commissions -- that will cut into your performance. The upshot: You could wind up wasting a load of money on transactions when you would be better off buying a sector fund and holding it for a decade.

Sector rotation is "extremely difficult, if not impossible, to do right," says Bryan Olson, director at Charles Schwab's Center for Investment Research. "It's another form of market timing."

To skillfully move your money from one industry into another, selling at every peak and buying at every valley, you must have an encyclopedic knowledge of how these industries work. You also must carefully follow each sector, watching for the signs that tell you to get in or get out.

Take semiconductor stocks. At the beginning of a business cycle, chip companies will start to see rising demand for their semiconductors from customers like PC makers. As demand increases, the supply of chips gets tight and prices rise, which benefits the chipmakers.

To produce more chips and meet this demand, the semiconductor companies need to build more plants, but it takes 12 to 18 months for new capital spending to actually produce more chips. By the time the chipmakers are producing more product, the customers have stockpiled their inventories and double-ordered. The result is a glut of chips.

This business cycle, which investors have seen time and again, drives the stocks. But in order to time a move into a chip fund and then out, you must closely follow the industry, looking for signs of chip shortages and surpluses.

For example, chip stocks were roaring in mid-1995, and many investors were buying into the sector. The Philadelphia Stock Exchange Semiconductor index had soared about 100% through August. At about that time, chips stocks turned and the index fell about 32% during the next 12 months. Just when most investors would think of buying semiconductor stocks, that industry started to head in the other direction.

Rather than trying to time the ups and downs of a chip-centric fund, you'd be better off buying one and holding it.

The (FSELX Quote)Fidelity Select Electronics fund, which invests primarily in semiconductor stocks, can be incredibly volatile, but the fund's 10-year record is undeniably fantastic: Its 10-year annualized return through the end of August is 42%, which puts it at the top of its category, according to Morningstar.

Over shorter periods, however, this fund can rise and fall like the tide. If you are jumping from sector to sector, there's a pretty good chance you would have missed some of the gains. To boot, the fund carries a 3% front-end load , or sales charge, as well as a 0.75% redemption fee for shares held less than a month.

If you're going to play the rotations of various industries, you'll also have to fight your instincts to buy too late and sell too soon. "The record shows that most of us would rather buy funds or stocks that have gone up," says Morningstar's Russ Kinnel.

You'll often see money flood into a fund after a fantastic year, only to see that fund stumble shortly thereafter.

Individual investors simply aren't very good at timing their stock selections. Terrance Odean, a professor of finance at the Graduate School of Management at the University of California-Davis, proved just that in a study he performed from 1987 through 1993 in 10,000 randomly selected accounts at a large discount brokerage firm. The study showed that the stocks people bought tended to do worse than the stocks they sold.

To play an industry's rotations or cycles, you have to be willing to buy into a sector that hasn't been doing well and to sell when things probably still look good. That's something that most investors arguably aren't capable of.

If you think you're above this reasoning, ask yourself: Would you have thought to buy a real estate fund at the beginning of this year?

The average real estate fund fell 15.6% in 1998 and was down another 2.6% last year, according to Morningstar. But this year, these funds have come back, with office space tight in many cities and rents on the rise. This year the average real estate fund is up 22%.

Maybe this is the top. Maybe it isn't.

You make the call. Better yet, maybe you shouldn't.

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