Five Winning Funds: A Second Look at Sectors

This week's Five Winning Funds highlights some of the best sector funds around.
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Of the countless new investment products thrown at investors in the 1990s, none was more exploited by mutual fund firms or misused by individuals than the sector fund.

Many investors, feeding off the rush of a tech addiction, scooped up two tech funds to go with their

S&P 500

index fund,

(FMAGX) - Get Report

Fidelity Magellan and

(JAVLX)

Janus Twenty -- all of which already had too much tech exposure anyway. Nonetheless, the folly has largely abated, except for a few greater fool theorists funneling money into Internet funds once again. (My humble advice: Don't get roped in by 50% quarterly gains at the outliers such as

(JAMFX) - Get Report

Jacob Internet.)

Now that mostly cooler heads prevail, investors can prudently examine sector funds as a way to achieve additional diversification and increased overall performance for their portfolio. This spring, I wrote an article detailing recent studies demonstrating the virtues of sector funds as a way to diversify, not gamble -- indeed, sector funds may offer better diversification than overseas funds. (Click

here to check out the story.) In today's Five Winning Funds, we'll offer some suggestions on the best sector funds from which to choose.

Before we mention our favorite sector offerings, let's make a few basic points. Sector funds should be used sparingly in an investor's portfolio -- they are spice, not the main course. For most individuals, 10% or less would suffice. Also, some sectors make more sense than others: Odds are, the mutual funds most investors own still hold a healthy portion of tech stocks, which still sport the highest valuations. The need for a tech fund is less urgent than, say, a real estate fund -- which asset-allocation strategists routinely recommend as a vital component of a diversified portfolio. Otherwise, the standard rules apply: Look for funds with low costs (there's no need to pay a load, or sales fee, for a sector fund, such as those levied by Fidelity's sector funds), steady management and solid long-term performance.

Lastly, before you run out and start buying sector funds, check under the hood of your portfolio to see what your sector exposure is currently. The easiest way to do so is Morningstar's worthy portfolio

X-Ray.

Healthcare: Vanguard Health Care

This was the easiest sector to pick. A reasonable argument can be made that the $16.83 billion-in-assets

(VGHCX) - Get Report

Vanguard Health Care is the best mutual fund in the world.

Consider performance: The fund's 10-year average annual return of 20.41% bests the S&P 500's average annual return by more than 10 percentage points. It is the only fund in Morningstar's database of more than 4,000 funds to have returned greater than 20% a year on average these past 10 years. Since its 1984 inception, the fund has returned 20.22% a year. Consider cost: The no-load fund's 0.31% expense ratio is comically low compared with the 1.72% category average. Consider management: Ed Owens has run the fund since the beginning.

Big Pharma names like

Pfizer

(PFE) - Get Report

and

Schering-Plough

(SGP)

place high among the fund's 100-odd holdings, but Owens also dabbles in the smaller fare. Indeed, in a recent

Fortune

article, he called Pennsylvania biotech company

Cephalon

(CEPH)

the most attractive stock he owns.

Lastly, the fund has not been closely correlated with the S&P 500, which means it makes a great diversification tool for a portfolio.

Technology: Pimco RCM Global Technology

This was the most difficult sector to pick. For one thing, the average tech fund has lost 32.3% a year over the past three years, according to Lipper. For another, I have a hard time imaging exactly what investor needs more tech in his or her portfolio. However, if a long-term investor wants to make a small additional bet on technology,

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Pimco RCM Global Technology looks like the best way to go.

Walter Price has helmed the Pimco RCM Global Technology fund since its December 1995 inception -- longtime co-manager Huachen Chen now works for the fund as an independent contractor -- and has shown a keen eye for stock-picking. Price's winning bets have tapped the mojo not only of highly speculative stocks such as China dot-com play

Sohu.com

(SOHU) - Get Report

(up a mere 550% this year), but also tech turnaround plays such as

Hewlett-Packard

(HPQ) - Get Report

.

Make no mistake, this fund has been pasted like every other tech fund, losing 29.4% a year on average the past three years -- which places it among the top 22% of all tech funds, sadly enough, according to Morningstar. Over five years, the 9.1% average annual return ranks in the top 6%. Investors looking for a tech fund should brace for a bumpy ride; price is one of the surest hands among the group.

One other caveat: The fund is available in an alphabet soup of share classes, including some that charge loads that make them prohibitively expensive. However, the

(DGTNX)

D shares are available as no-load funds through some brokers. Still, the 1.63% expense ratio, while less than the 1.97% expense ratio of the average tech fund, means the fund still ain't cheap.

By the way, there are "safer" tech funds. Solid

(NTCHX)

Northern Technology, for instance, is loaded to the gills with "blue-chip tech" stocks such as

eBay

(EBAY) - Get Report

,

Yahoo!

(YHOO)

and

Dell

(DELL) - Get Report

. However, every investor in America probably owns those three stocks (Northern's top-three holdings) somewhere in their fund portfolio. Investors may not own

UTStarcom

(UTSI) - Get Report

,

Yahoo! Japan

,

Amdocs

(DOX) - Get Report

and

Marvell Technology

(MRVL) - Get Report

, which turn up in Dresder RCM Global Technology's Top 10 -- making that fund a better way to get exposure to a more diverse array of tech stocks.

Financial: T. Rowe Price Financial Services

The T. Rowe Price fund family reminds one of a great sports franchise that manages to win most of the time without being overly dependent on a star manager. That's why the recent manager change at

(PRISX) - Get Report

T. Rowe Price Financial Services shouldn't deter investors away from this sound sector-fund option.

The $290 million fund delivers on the basic goals. Expenses are low: The no-load fund's 1% expense ratio is well below the 1.77% category average. Performance is above average: The one-year return of 19.53% and five-year average annual return of 6.24% both rank in the top 14% of all financial-services funds, according to Morningstar.

The skipper, Michael Holton, has been at the helm since November 2002 and with T. Rowe for seven years, according to T. Rowe Price's Web site. Like all T. Rowe funds, Holton is backed by a deep bench of analysts. The fund loads up on fairly conservative financial-service stocks such as

Citigroup

(C) - Get Report

.

Real Estate

Make it two for T. Rowe Price.

No-load

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T. Rowe Price Real Estate is a safe-and-sound all-around bet for most investors looking to add real estate to their portfolio.

Among the benefits of the $160 million-in-assets fund: A solid manager in David Lee; an expense ratio of 1%, below the 1.64% category average; and performance that has consistently outpaced the majority of its peers.

The fund has returned 13.80% a year on average over the past three years and 8.63% a year over the past five years -- placing it in the top 32% and 21% of all real estate funds, according to Morningstar. The fund's 4.94% dividend yield helps ensure steady returns. Like most funds in the category, its bets are fairly concentrated: It holds 37 stocks in the portfolio. However, Lee, at the helm since the fund's 1997 inception, takes a risk-averse, value-oriented approach to the group, which has led to steadier, safer returns than many of the fund's peers.

The real estate sector has no shortage of good funds, by the way. Check out

this recent Five Funds to dig for other picks.

Utilities: Alliance Bernstein Utility Income

There are plenty of decent utilities sector funds, as well. The problem is many of them sport hefty load fees that eat into returns. One that skips the load fees while offering above-average returns is

(AUIYX) - Get Report

Alliance Bernstein Utility Income.

The $206 million fund, run by Paul Rissman since its 1996 inception, invests in a wide range of electric, telecom, cable and energy utilities --

Comcast

(CMCSA) - Get Report

and

Verizon

(VZ) - Get Report

turn up in the top 10 -- and has adopted a more conservative bent to avoid some of the big minefields of the past few years. The fund's three-year and five-year average annual returns -- minus 8.86% and positive 1.21%, respectively -- rank in the top fifth of all utilities funds.

The 1.16% expense ratio is below the 1.43% category average.