Old Saws Don't Apply When Picking Winning Fund Sectors

Health care funds are tanking, techy communications funds are soaring, and the world is making a little more sense.

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Conventional wisdom tells us that if you want to find next year's leading sectors, look at this year's laggards, and vice versa. True to form, health care funds, which beat all other fund sectors with a 55% gain last year, are dead last with an 11.3% average loss since Jan. 1. And communications and technology funds, last year's worst two sectors with more than 30% losses, are this year's early leaders. (For a look at the bottom five health care funds and the top five communications funds, click here.)

Ah, finally a bromide you can count on in this messy environment. Too bad it's bunk.

OK, that might be a bit harsh, but this worst-to-first idea is right a little less than half the time. This, of course, means it's wrong a little more than half the time. Let's take a closer look at this simplistic saw and then check out a tweaked version. This one can actually give you some insight into market's shifting favor and -- if used with a small portion of your portfolio -- can actually make you some money.

It's intriguing -- not to mention comforting -- to think that the stock market moves in convenient patterns, obediently shifting gears each time we roll into another year. Unfortunately, this doesn't make much sense. If that were the case, we'd all be rich because it wouldn't matter much what we bought as long as we knew when to buy it. But that idea calls for parity and regularity. If it were true, tech funds, for instance, wouldn't have ranked in the top-three sector-fund performers in seven of the last 10 years, which they did.

2000 By the Numbers
Sector-Fund Category	2000 Return
Health Care	55.4%
Natural Resources	30.4
Financial Svc.	27.1
Real Estate	25.8
Utilities	7.2
Communications	-32.6
Technology	-33.1
S&P 500	-9.1
Source: Morningstar.

Given sector funds' performance last year, now we'd focus on the losers: technology, communications and utilities funds. One or all of these sectors might go on to be this year's winners, or they might not. Either way, rather than assume a winner will morph into a loser, it probably makes a lot more sense to focus on their stocks' valuations and the industries' growth prospects over the next five or 10 years in light of demographics or regulatory changes. The short version: Could I buy the same growth for less elsewhere?

The upshot: While a lousy year might provide you with a solid entry point into a sector investment, it shouldn't be the sole driver of your interest.

And then there's the key point that this worst-to-first thing just doesn't work that well as a divining rod. Over the last five calendar years, sector fund categories that ranked in the bottom three one year vaulted into the top three the following year less than half the time.

Heads or Tails The worst-to-first theory only proved true a little less than half the time in the last five years. Highlighted sectors were losers the previous year.
1996	1997	1998	1999	2000
Natural Res.	Financial Svc.	Technology	Technology	Health Care
Real Estate	Communications	Communications	Communications	Natural Res.
Financial Svc.	Utilities	Utilities	Natural Resources	Financial Svc.
Source: Morningstar.

This knee-jerk strategy was an even worse predictor over the last 10 calendar years when losers bloomed into winners less than four times out of 10. Even if we take a broader view, comparing losing sector-fund packs vs. the S&P 500 the next year, the bet still has the same odds as a coin flip.

Of course, there is a version of this strategy that works a bit better. Each year, the folks at Morningstar pick three "unloved" diversified or sector fund categories where investors' net investments were lowest that year. The good news is that, going back to 1987, each year's unloved fund flavors have beaten the average stock fund over the next three years more than 75% of the time.

The bad news is that the pattern, though intriguing, is only suitable for a small portion of most investors' portfolios in tax-deferred accounts like an IRA or 401(k), because the highlighted categories are usually oddballs.

For instance, if you'd dutifully followed this strategy since 1987, the categories highlighted most often have been convertible bond funds and various Japan/Asia funds -- hardly core holdings. At the end of 1999 the firm highlighted Latin America funds, precious metals funds and convertible bond funds. (The 2000 loser class won't be named until next week.)

Losers of the Year Awards
1987	Japan, Pacific ex-Japan, Foreign
1988	Europe, Convertibles, Health Care
1989	Convertibles, Real Estate, Technology,
1990	Convertibles, Real Estate, Technology
1991	Convertibles, Natural Resources, Europe
1992	Natural Resources, Health Care, Precious Metals
1993	Health Care, Financials, Technology
1994	Utilities, Health Care, Convertibles
1995	Precious Metals, Communications, Europe
1996	Utilities, Communications, Latin America
1997	Communications, Pacific ex-Japan, Pacific/Asia
1998	Natural Resources, Latin America, Pacific ex- Japan
1999	Latin America, Precious Metals, Convertibles
2000	N/A
Source: Morningstar.com.

For its part, Morningstar doesn't claim its annual losers are a buy list.

"I think this is a helpful piece of information, but it's just one of many," says senior fund analyst Scott Cooley. "It's a way to home in on areas people have given up on, but you still want to do something that makes sense in the scheme of your whole portfolio. Putting a big part of your money in a small part of the market doesn't make sense for anyone."

While this strategy's performance record might be impressive, keep in mind that beating the average stock fund isn't necessarily that tough because there are enough bad and expensive funds out there to make that a fairly low bar.

Consider that the plain vanilla (VFINX Quote)Vanguard Index 500 fund, which tracks the S&P 500 Index, beat the average U.S. stock fund over the last three-, five-, 10- and 15-year time periods, according to Morningstar -- including five consecutive years between 1994 and 1998.

If you want to fold this strategy into your portfolio, Cooley suggests spreading your exposure to unpopular categories by owning a fund in each basket -- while also limiting your exposure to about 5% of your portfolio -- 10% at most. Also, it's a good idea to use this strategy in a tax-deferred account because this strategy assumes your unwinding your holdings in these funds after three years, and taxes can take a big bite out of any gains you reap.

For my money, I'd skip fund strategies where you're planning to own a stock fund for less than five years. Instead, I use this data as a way to see exactly what investors hate. That's often a good barometer of sentiment and an indication of where I might want to put my mad money -- roughly defined as the money you'd bring to Vegas if you were so inclined. I just can't bring myself to own a gold fund.

The closest I come to this strategy is in rebalancing where I simply adjust my allocation with new money, bring my stakes in losing categories back up to my target weightings. It might not be sexy, but that's why we have mad money -- to keep ourselves out of trouble.