Sector funds that concentrate on stocks in a particular industry have been around for a long time, but a new breed of sector funds that trade like stocks offers a promising strategy for the aggressive investor.
Some of the early sector funds, such as the
T. Rowe Price New Era fund, invest in utilities or energy or precious metals with the notion that these sectors might provide a buffer against the overall stock market in a downturn.
gave sector funds a twist in 1981 when it introduced its sector portfolios designed to attract investors who anticipate a period of outperformance in a particular sector.
That's the idea, too, behind the 30 or so sector funds that trade on the American Stock Exchange as exchange-traded funds, or ETFs. Most of these funds take the stocks in a broad index, such as the
Standard & Poor's 500, and split them into industries.
The Appeal of 'Spiders'
The nine S&P sector ETFs were introduced in 1998. The 500 stocks in the S&P index are sorted into nine baskets: consumer services, consumer staples, basic industries, cyclical and transportation, energy, financial, industrial, technology and utilities.
The S&P funds are called the "sector spiders" because of the nickname for the exchange-traded fund that invests in the overall S&P 500 index: SPDR Trust, shorthand for the Standard & Poor's depositary receipt. The sector spiders are large-cap sectors; investors who buy them are betting on the big-cap stocks in the S&P 500.
Some investors complain that these sectors lack purity; for instance, the technology sector is not pure technology. But that objection is not unique to exchange-traded funds. Managed mutual funds are often guilty of betraying their mandate. I remember when the regional-bank-oriented
Fidelity Select Banking fund invested in money-center banks, and the
Fidelity Blue Chip Growth fund invested in emerging companies.
Quest for Purity
Today, there are purer tech indices, too. Goldman Sachs offers a technology exchange-traded fund, a networking fund, a semiconductor fund and a software fund. In addition, iShares are available that invest in the Dow Jones Internet index, the technology index and the telecommunications index.
(iShares is the brand name for exchange-traded funds offered by
Barclay's Global Investors
, the largest index fund manager. In all, there are 14 Dow Jones sectors available in iShares.)
S&P does not offer a health care sector. The S&P health care stocks are divvied up among other sectors. But there is the
iShares Dow Jones U.S. Healthcare Sector Index
fund that invests in the Dow Jones listing of health care providers, biotechnology companies and manufacturers of medical supplies, advanced medical devices and pharmaceuticals. There's also the pure
iShares Nasdaq Biotech Index
How Much Is Management Worth?
The question to ask when considering index sector funds is, how much is active management worth in an industry sector? There are two schools of thought on this. Some investors say managers are worth their weight in gold; others say they are expensive and worthless.
I'm somewhere in between. For instance, I'm a big fan of Ed Owens, manager of
Vanguard Health Care, a fund I own. So I compared that fund, where I think the manager adds a lot of value, with the Dow Jones U.S. Healthcare Sector Index fund. What I discovered was that although they moved in sync, the index fund had a stretch of outperforming the Vanguard fund earlier this year. The sector fund did not underperform at all. But the Vanguard Fund carries a $25,000 minimum, which frustrates many beginning investors. For them, the health care sector fund seems worth a look.
There are certain industries I would never invest in, such as transportation or utilities, though I can imagine that some investors might consider them. Others, such as tech and health care, I like. Because these industries are cyclical, the sector funds can make sense.
When I compared various sectors with the overall market, I saw that basic materials, which represents an investment in commoditylike stocks, was one of the best-performing sectors this year, with energy not far behind. (Goldman Sachs will try to capture the performance of basic materials with its new
Natural Resources Index
fund.) The Internet sector was the worst, with technology close. You can study these sectors for yourself by going to the
iShares Web site and looking at sector performance over various periods.
Finding the Overperformers
One way to use sectors is to pick those you expect to be long-term winners and then sit tight. A second is to invest in the sector that you believe is poised for a turnaround. Right now that looks like tech. The Internet sector is too much of a long shot for me.
A third strategy is to look at a stock, mutual fund or sector that has had an extended period of overperformance. An investor could identify the overperformers in one month, and then invest in them for a second month, and then rotate out of them to the new overperformers.
New tools and toys can be overwhelming, and we must resist the urge to trade too much and buy too much just because they're available. On the other hand, the tools available online to you and me today were available only to professionals a couple of years ago, and we may as well take advantage of them.
At the time of publication, Mary Rowland owned the following equities mentioned in this column: Vanguard Health Care and the Nasdaq 100 Trust.