Sector Offerings Are Best Taken in Small Doses

If anyone needed evidence that any sector mutual fund can be a flash in the pan, it came a couple of weeks ago from the Oppenheimer funds group.

That’s when the New York firm announced it will ask shareholders in its Global Bio-Tech fund to vote Sept. 19 on a proposal that would change the fund’s name and investment strategy, essentially transforming Bio-Tech into a broader emerging-growth portfolio.

Makeovers are nothing new in the mutual fund business, but it’s rare to see fund companies tinker with what recently had been such a winning formula. In 1991, Oppenheimer Global Bio-Tech had the winningest formula of all. It scored a sizzling 121% gain and finished as the top mutual fund that year.

But in the 2 1/2 years since then, the threat of health care reform has sedated the fund, which depreciated more than 40% since January, 1992, and has seen shareholders dwindle.

This episode underscores the high-profit, high-risk nature of sector portfolios, which, unlike most other mutual funds, concentrate their holdings in the stocks of a particular industry.

Because they lack diversification, these funds can be especially volatile and vulnerable to investment fads. They are best handled in small doses, if at all.

“The idea of sector funds is a good one, but I think most people tend to switch in and out at the wrong times,” says Larry Marx, co-manager of Neuberger & Berman’s Selected Sectors fund in New York.

That certainly happened last year to utility portfolios, the single largest sector-fund category.

On the tail end of a decade of exceptionally good returns, shareholders flooded into these funds in 1993, boosting their collective assets to $27 billion from $17 billion in 1992, according to Lipper Analytical Services of Summit, N.J. So what did these new shareholders get in return? An average 9.9% loss during the first half of 1994.

Besides the recent woes to hit the health and utility areas, other sector setbacks have befallen gold, environmental, energy/natural resources and, to a lesser extent, real estate portfolios within the last five years. However, the financial and technology industries have done well.

What keeps people coming back to sector funds is their explosive profit potential. This potential was illustrated recently in a simple study by the Value Line Mutual Fund Survey, a fund-tracking publication based in New York.

Value Line wanted to see how well investors watching a short list of just five sectors--financial, energy/resources, gold, technology and utilities--could have fared if they were able to put all of their money into what turned out to be the top industry each year.

Value Line tracked the performance of these five sectors from 1973 through 1993 and determined that someone able to predict each year’s winning industry would have earned a sizzling 34% compounded annual return, equivalent to turning a $10,000 initial investment into $4.65 million.

This sector strategy would have done substantially better than, say, accurately timing every 5% move up or down in the Standard & Poor’s 500 index over the same 21-year period. An astute market timer able to turn this nifty trick would have scored a 27% compounded return, converting the original $10,000 into $1.52 million.

Simply buying and holding an S&P; 500 fund would have generated an 11% compounded return, boosting the $10,000 to about $96,000.

But does this mean investors should line up to buy sector funds?

No way, says Value Line’s editor, Stephen Savage.

“The main point (of the study) was that fund managers can add more value through wise security selection than they can by trying to time the market,” he says.

Sector funds were merely used to illustrate the highest potential of astute stock-picking.

Neither scenario outlined in the Value Line study is realistic. Nobody could time every 5% swing in the market for more than two decades. Nor could a sector investor pick the top industry for 21 consecutive years.

So how should investors regard sector funds?

Savage recommends that investors keep their sector-fund holdings to a maximum 10% of assets. But even these should be long-term plays rather than bets on next quarter’s or next year’s hot industry.

Investing heavily in what turned out to be the worst sector each year would be more disastrous than missing every market turn, Savage adds.

Another approach would be to let a fund manager do the sector surfing for you.

For example, Marx and co-manager Kent Simons focus the Neuberger & Berman fund around five or six sectors at any one time, as opposed to the much broader diversification typical of most funds.

The managers follow a value-oriented investment style to reduce the odds of buying into an industry near its peak. Currently, most of the fund’s assets have been put to work in financial, technology and media/entertainment firms.

Neuberger & Berman Selected Sectors (no-load; (800) 877-9700) got off to a rough start after it was renamed and restructured in 1989, but it bounced back to beat the market in 1992 and 1993, and it’s slightly ahead so far this year.

Some other funds with decent track records that tend to follow a sector-concentrated approach include the Clipper fund (no load; (800) 776-5033), Crabbe Huson Special (no load; (800) 541-9732), New Economy (5.75% load; (800) 421-0180), Putnam New Opportunities (5.75% load; (800) 225-1581), Third Avenue Value (4.5% load; (800) 443-1021) and Warburg, Pincus Growth & Income (no load; (800) 257-5614).

Rather than take big bets on just one sector, all of these funds tend to spread their holdings among at least half a dozen industries.

*

Wrap-fee accounts that make use of mutual funds aren’t necessarily cheaper than those that utilize individual stocks and bonds, warns Cerulli Associates of Boston. Even so, the consulting firm reports that fund-oriented wrap programs are on the upswing.

In the traditional wrap program, a broker helps an investor select and monitor an appropriate money manager, who tailors a portfolio of stocks or bonds for that person. All trading commissions as well as compensation for the broker and manager are wrapped into a single fee of 2.5% to 3% a year.

With wrap programs built around mutual funds, the broker’s yearly pay runs about 1% to 1.5%, but regular fund expenses also must be considered. “Adding the two types of fees, the total costs of participating in mutual fund wraps can surpass 3% in some programs,” says Cerulli Associates.

A more obvious benefit for investors is that fund wrap programs typically require only a $25,000 minimum investment, compared with $100,000 on programs built around individual stocks and bonds.

*

The Invesco Funds Group of Denver is coming out with two new global sector funds in August. The company’s Worldwide Capital Goods fund hopes to profit from the global restructuring trend, which has made manufacturers more efficient. Invesco’s Worldwide Communications fund will invest in telephone, computer, entertainment and similar types of firms around the globe.

Both funds ((800) 525-8085) require a $1,000 minimum investment and are marketed without a sales charge or load.