Sector Funds Add Spice but Also Risk Heartburn

Being average is usually nothing to write home about, but the average U.S. stock mutual fund shareholder is sitting on a 21% gain so far this year--a handsome return by any measure.

Still, many fund owners know they could have done even better by being in the hottest segments of a hot market. Technology is the obvious one, but in fact this has been a standout year for many non-tech industry groups as well.

Which is why “sector” stock funds--which focus on companies in specific industries--get a lot more investor attention at times like this. They make it look easy to beat the average market return and significantly spice up your portfolio’s gains.

Consider: Of Fidelity Investments’ 35 “Select” stock funds, each of which targets a single industry, 21 (or 60%) have beaten the average general stock fund’s 21% gain year-to-date, according to fund-tracker Lipper Analytical Services Inc.

The big winners include Fidelity’s Select Electronics fund, up 77.9%; Select Airlines, up 50.6%; and Select Industrial Equipment, up 32.7%.

Fidelity has the widest array of sector funds, but most large fund firms offer one or more funds that are industry-specific. There now are 88 utility-stock funds, for example, 39 technology funds and 38 natural resources funds, Lipper says.

While many investors probably view sector funds as short-term, highly speculative market bets, some of the funds have been excellent buy-and-hold investments.

In the 10 years ended June 30, the four health care funds that have existed for that entire period rose 443% on average, compared to a 244% rise in the average diversified growth-stock fund, Lipper says.

In the technology-fund sector, the 10 funds in existence for the past decade have gained 377% on average--which shows that technology, as an investment, has been much more than the flash-in-the-pan some of its detractors are alleging this year.

Do sector funds have a place in the typical investor’s portfolio? Many fund experts have traditionally been wary of such narrowly focused funds, arguing that only a relative few people have the knowledge, patience and sense of timing necessary to invest successfully in the funds.

Besides, by definition, sector funds defy one of the basic rules of mutual fund investing--the idea of diversification. Just as with individual stocks, sector funds are “a high-octane investment that can do very well--or very poorly,” notes Kurt Brouwer of San Francisco-based Brouwer & Janachowski, which picks mutual fund portfolios for individual clients.

As sexy as the gains in technology funds have been over the past decade, investors who bet heavily on another once-promising field--the environmental business--have suffered disastrous performance.

The three environmental stock funds in existence for the past five years have averaged a gain of just 2%, compared to a gain of 72% for the average growth-stock fund.

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Nonetheless, some pros have warmed to the sector-fund concept as a way of potentially jazzing up portfolio returns.

Robert Markman, whose Markman Capital Management in Minneapolis builds fund portfolios for clients, thinks a technology fund would make an intelligent addition to many investors’ fund lineups.

Although tech stocks have been gripped by a speculative fever this year, Markman believes “we’re only in the fourth or fifth inning” of a boom cycle for technology.

Despite the widely held view that even many diversified stock funds have invested too heavily in tech, he argues that “by and large most funds are underinvested in that area,” which he sees as the business “the world is moving toward.”

So he is using such technology-heavy funds as Seligman Communications & Information (now closed to new investors), Robertson Stephens Value Plus Growth and Twentieth Century Vista Investors to bolster clients’ stakes in tech issues.

Markman concedes that sector funds, and tech funds in particular, can be extraordinarily volatile. What he asks clients to visualize is someone walking up a flight of stairs while playing with a yo-yo. The idea is that there will be many harrowing short-term ups and downs in a sector fund, but if the business is fundamentally attractive the fund’s rise over time should be significant.

Sector funds’ critics, however, say the funds’ volatility is precisely the problem. “It’s just very, very hard for people to own these funds through their down periods,” says John Rekenthaler, publisher of fund evaluator Morningstar Mutual Funds in Chicago.

What inevitably happens, Rekenthaler says, is that many sector-fund investors buy in at an industry’s cyclical peak and sell out at its cyclical lows.

As an example, he cites the experience of the Fidelity Select Biotechnology fund. In 1991, after three years of spectacular gains, the fund’s assets ballooned from $224 million to $1.1 billion as investors poured in.

In 1992, biotech stocks began to crash. By the beginning of this year, after three years of awful performance, the Fidelity fund’s assets were down to $396 million--and suddenly, biotech stocks began to resurge.

Rekenthaler argues that most investors are better off in diversified stock funds, leaving to the fund manager the decision about which market sectors are most attractive at any given moment.

But if you’re intrigued with the sector-fund concept, here are some experts’ tips on how to invest:

* Buy into industries about which you have some special knowledge. In other words, do your homework, and have more than just a gut feeling about why a particular sector looks promising.

* Ask yourself where the industry appears to be in its cycle. (Most businesses are cyclical to some degree, after all.) “You have to be there early on” to really have a sector bet pay off, notes Brouwer. He advises sector-fund buyers to think “contrarian,” meaning that they should look for sectors that have been out of favor for an extended period--and sell when a sector becomes excessively popular.

* Realize that sector funds’ management fees and trading expenses often are above-average, which can dampen your returns. And before you decide to buy a fund, check the front-end sales charge and whether there is a redemption fee. Fidelity’s Select funds, for example, have a 3% upfront charge and a redemption fee of as much as 0.75% when you sell.

* Use sector funds as spice, not as core portfolio holdings. “These funds are bets, not an investment program,” says Michael Lipper of Lipper Analytical. At most, sector funds should make up 30% of your total fund assets, and for most people they should be less than that, he says. Remember: The more sector funds you own, you run the risk of creating just another diversified mix of stocks no different from a regular mutual fund--and probably at higher cost.

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Dissing Disney: Wall Street seemed totally captivated last week by Walt Disney Co.’s decision to spend $19 billion buying Capital Cities/ABC Inc. A spectacular strategic move for Disney, nearly everyone agreed.

Not so Jeff Bronchick, money manager at $700-million-asset Reed, Conner & Birdwell in West Los Angeles. The firm owned about 200,000 shares of Cap Cities, and was more than happy to sell in the open market at $119.50 a share last week rather than wait to receive cash and Disney stock when the deal closes.

Bronchick, a conservative type at a generally conservative firm, argues that Disney is paying “top dollar [for Cap Cities] at the top of the cycle” of network advertising, as Wall Street looks ahead to the election and Olympic year of 1996.

More disturbing to Bronchick is what he regards as Wall Street’s universal unwillingness to question the purported benefits to Disney of the Cap Cities acquisition.

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The potential problems, as he sees them:

* “Disney can’t do one cent of additional cost-cutting at Cap Cities, because that operation is already run so tight.”

* “The jury is still out on the wisdom of vertical integration of entertainment companies,” meaning joining a studio with a distribution network. It hasn’t exactly worked wonders for Time Warner.

* Most important, “There is very little these two companies [Disney and Cap Cities] can do together that they couldn’t have done on their own,” Bronchick argues.

Disney could have joint-ventured projects with Cap Cities or cut any number of new global TV or cable deals for its programming, Bronchick says. There was no need to spend $19 billion, he contends.

Long term, the marriage may prove a good deal for Disney shareholders, Bronchick allows. But near term, he thinks Wall Street’s doubts will grow, and that shareholders will increasingly fret about what he foresees as paltry early returns on that $19 billion.

Disney stock, at $58 on Friday, “will see $50 before it sees $70,” Bronchick declares.

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The Specialty Funds: A Long-Term View

Mutual funds that specialize in stocks of specific industries have a mixed track record over the past 10 and five years compared to general diversified stock funds. Average fund performance through June 30 for five specialty fund categories, compared to the average U.S. growth stock fund’s gains:

* 10-YEAR PERFORMANCE

Health care: 443%

Technology: 377

Average growth fund: 224

Financial services: 241

Environmental: 178

Natural resources: 140

* 5-YEAR PERFORMANCE

Technology: 161%

Financial services: 157

Health care: 100

Average growth fund: 72

Natural resources: 29

Environmental: 2

Source: Lipper Analytical Services Inc.