There’s Logic in Going for Group of Sector Funds

Sector mutual funds are notorious for being poorly diversified and risky, which probably explains why a lot of investors don’t use them.

But the funds aren’t so bad if you use several at once, suggests a new study by Morningstar Inc. of Chicago.

Sector portfolios are unusual types of mutual funds that target a single industry--be it the utility business, gold mining or whatever. Some industries, such as technology and health care, are quite broad. But even sector products that target these areas won’t provide as much diversification as a mainstream mutual fund.

Because they’re narrowly focused, sector funds tend to be about 50% more risky than mutual funds generally, according to Morningstar. But the company’s study challenges the conventional wisdom that sector funds are best used sparingly, if at all.

“When combined intelligently . . . they actually can function effectively as a portfolio’s core,” writes Assistant Editor Kurt Kunert in the January issue of the Morningstar Investor newsletter, which published the study.

Because sector-fund managers limit their choices to a smaller range of companies, “[they] ought to be able to pick better stocks within an industry than . . . managers who have the entire stock market to wade through,” Kunert reasons.

Morningstar back-tested the performance of 10 sector funds from January 1990 through November 1995. The 10 funds mirrored key industries in the Standard & Poor’s 500 index at the start of 1990.

When it came to picking individual funds, Morningstar selected those with the best performance records before January 1990 so as not to skew the results with 20-20 hindsight.

Of the 10 funds chosen, six were from Fidelity Investments of Boston. These were Fidelity’s Select Automotive, Chemicals, Food & Agriculture, Regional Banks, Retailing and Telecommunications products. Also included were Invesco’s Strategic Health Sciences and Leisure funds, both of Denver, along with Vanguard Specialized Energy of Valley Forge, Pa., and Franklin Dynatech of San Mateo, Calif.

Morningstar found that this 10-fund mix appreciated 137% over the 71-month study period, even after deducting sales charges.

That’s well above the 98% gain for the average mainstream stock fund and the 103% rise for the Vanguard Index Trust 500, a mutual fund that replicates the S&P; 500.

“Our quirky collection of specialty funds not only ended up a winner, but it achieved superior results without taking on excess risk,” writes Kunert.

But is it realistic to build your portfolio around sector funds?

Shirley Binder, president of the Masters Investment Group in Phoenix, uses certain sector funds to round out client portfolios but does not rely on them exclusively.

Sector funds require more research and monitoring and might not make sense for buy-and-hold investors.

“You would really have to be cognizant of what’s happening in the business cycle around you,” she says.

Also, the strategy wouldn’t be suitable for investors who can’t stomach the jolting ride of sector funds, whose prices can be expected to bounce around, says Thomas Bellhy, president of Fort Pitt Capital Group in Pittsburgh.

Another problem involves minimum investments. In 1990, you would have needed $9,600 to buy into the 10 sector funds. This reflects a $1,000 minimum for each Fidelity portfolio, plus $250 at Invesco, $3,000 at Vanguard and $100 at Franklin. Since then, the minimum stake for the same 10 products has risen to $20,100 because both Fidelity and Invesco have raised their thresholds.

If all this does not discourage you, the clutter problem might. For ample diversification, you would still need more than just 10 funds tracking various U.S. industries. You might also want a bond fund or two, along with holdings in foreign and small stocks. Adding these categories could easily push your total to 20 or so mutual funds.

Morningstar’s study provides a reason for why you may want to own a sector fund or two, but it doesn’t overcome the practical problems of relying on these products exclusively.

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A Winning Sector Portfolio

A recent study by Morningstar Inc. of Chicago challenges the conventional wisdom that industry sector funds are best used sparingly if at all. The company backtested the performance of the following 10 industry-specific funds from January 1990 through November 1995 and found that, as a group, they outperformed the average mainstream mutual fund.

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Sales Miniumum Name charge investment Phone Fidelity Select Automotive 3% $2,500 800-544-8888 Fidelity Select Chemicals 3 2,500 800-544-8888 Fidelity Select Food & Agriculture 3 2,500 800-544-8888 Fidelity Select Regional Banks 3 2,500 800-544-8888 Fidelity Select Retailing 3 2,500 800-544-8888 Fidelity Select Telecommunications 3 2,500 800-544-8888 Franklin DynaTech 4.5 100 800-342-5236 Invesco Strategic Health Sciences None 1,000 800-525-8085 Invesco Strategic Leisure None 1,000 800-525-8085 Vanguard Specialized Energy None 3,000 800-662-7447

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Note: The Fidelity and Vanguard funds come with small redemption charges.