Despite a Rough Year for Some, Sector Funds Can Be Solid Bets

Technology sector funds led the stock market’s fourth-quarter rally, but they still finished 2001 with an average loss of 38.3%--the biggest decline of any major fund category last year.

Communications sector funds had almost as bad a year, losing 34.6%, on average, according to Morningstar Inc. data.

And utility sector funds, once thought of as an investing haven for widows and orphans, tumbled 21.2% in 2001, thanks in part to the hard-hit telecom stocks many of them hold.

Investors who got used to big winnings in sector stock funds in the 1990s found out last year just how risky these narrowly focused portfolios can be.

Yet some financial advisors say sector funds still can be an effective tool for short-term traders, as well as a good idea for buy-and-hold investors, if used properly.

Despite a 13.4% loss last year, the average health-care sector fund has rewarded long-term investors with a gain equivalent to 15.2% a year over the last five years, according to Morningstar. That far exceeds the 9.1% annualized gain of the average domestic stock fund in that period.

Sector funds allow investors “to play offense or defense, or simply to fine-tune the investment mix,” said Jim Lowell, editor of the Fidelity Investor newsletter in Potomac, Md., which analyzes the mutual fund giant’s 41 sector funds, as well as its other offerings.

“One advantage of sector funds is that they allow you to finely parse the investment universe,” Lowell said. For example, if you have significant faith in a particular industry but aren’t sure about the best individual stocks to play, you can use sector funds to make a bet on the industry without limiting yourself to a particular stock.

Sector funds are big business for many fund companies: The combined assets of eight major stock sector fund categories tracked by Lipper Inc. total about $180 billion. By contrast, diversified small-stock funds hold about $150 billion in assets, according to Lipper.

Because sector funds concentrate on stocks within one industry or a cluster of closely related industries, they tend to be highly volatile, naturally gyrating with the fortunes of that segment of the economy.

Short-term traders can capitalize on that volatility by trying to ride hot sectors with a portion of their money, said Paul Merriman, head of Merriman Capital Management in Seattle and editor of the newsletter FundAdvice.com.

Merriman recommends spreading money earmarked for short-term sector investment among four fund sectors at a time to limit the risk. His strategy is to play those sectors that have the strongest share-price momentum in the last 100 trading days.

But investors trying to play short-term market moves obviously has to stay fast on their feet, experts say.

“The problem with sector investing is that it’s not just important when you get in, but also when you get out,” Lowell said. “If you’re not careful you can end up like Jimmy Cagney [in ‘White Heat’] screaming, ‘Made it, Ma! Top of the world!’ while the natural gas tank under you is about to explode. You have to be much more vigilant than with a diversified fund.”

Merriman said many of the traders who follow his recommendations adjust their sector portfolios daily or weekly rather than monthly, for example. As he put it, “A lot of bad stuff can happen to an industry in 30 days.”

Because of the potential for extreme ups and downs, sector investing demands discipline if you’re a short-term trend player.

“You must be willing to cut your losses short and to go back into a sector at a higher price than you got out at” if the trend turns positive again, Merriman said. “In other words, you have to admit mistakes, which some people can’t do.”

For short-term traders, Merriman recommends using sector funds from Rydex or ProFunds, which carry no upfront sales fees and no redemption charges. (Fidelity Investments’ Select sector funds, by contrast, which carry a 3% front-end sales charge and a redemption penalty if sold within 30 days, are geared toward longer-term investors.)

For true daredevils, ProFunds offers funds designed to perform at roughly 1.5 times the underlying sector--up or down--on a daily basis, by using borrowed money to amplify their bets.

As of last week, Merriman, whose fund picks are available free via e-mail service from the Web site SoundSectorStrategy.com, suggested ProFunds customers be invested in ProFunds Ultra Technology, ProFunds Ultra Semiconductor, ProFunds Ultra Basic Materials and ProFunds Ultra Real Estate, and that Rydex customers own Rydex Precious Metals, Rydex Consumer Products, Rydex Biotechnology and Rydex Basic Materials.

Looking forward six to nine months, Lowell said one of his intermediate-term sector recommendations is a defensive play: He recently upgraded Fidelity Select Gold as “a hedge against the Fidelity Growth Company fund in times of geopolitical uncertainty.”

Lowell’s other intermediate-term picks are linked to the idea of a turnaround in the economy: Fidelity Select Energy and Fidelity Select Natural Gas, which could benefit from a pickup in manufacturing, and Fidelity Select Business Services, which could benefit if companies wary about hiring back employees instead turn to temporary agencies as a stopgap, he said.

Despite their volatility and popularity with short-term traders, sector funds can pay off as long-term investments, financial advisors say.

Financial-services sector funds have gained 12.8% a year over the last five years, on average, according to Morningstar.

And before the plunge of 2000 and 2001, the average technology sector fund produced double-digit returns for nine years straight.

The danger is that a sector can go cold for a long period too. Unlike a manager of a diversified stock fund, a sector fund manager, by definition, has to stick with a sector through thick and thin.

Precious metals sector funds gained 20.2% last year, on average, but they’ve had a dismal last five years as gold has fallen out of favor. The average fund’s five-year annualized return is a negative 11.6%.

The natural resources sector also has been a poor performer over the last five years, gaining just 3.2% a year, on average.

Lowell said the two sector funds he would feel comfortable “buying today and leaving in a safe deposit box for 15 years” are Fidelity Select Health Care, which he said offers growth potential with relatively low volatility, and Fidelity Select Electronics, which focuses on computer chip companies.

He said he would steer clear of making long-term bets in cyclical heavy-industry sectors such as energy, chemicals and autos.

Buy-and-hold investors should be especially mindful of what their sector fund actually owns, Merriman cautions. “A utility fund cries out ‘conservative’ but, as people have found out, it’s not necessarily so,” he said.

Blowups such as Enron Corp., the energy trader whose stock collapsed in the fall when questions arose about its convoluted accounting, can take a big toll on even standout sector funds, Morningstar notes. MFS Utilities, which still has a strong long-term record under manager Maura Shaughnessy, sank 25% last year thanks in part to the Enron debacle.

Investors also should be aware of trading costs and tax considerations when using sector funds, experts say.

Sector investors who trade rapidly and generate significant short-term capital gains may be best served investing via a tax-advantaged vehicle such as an individual retirement account, Lowell said.

There also is an alternative to traditional sector mutual funds: Exchange-traded funds, which track various indexes but trade throughout the day like individual stocks, provide another way to invest in sectors. ETFs tend to be tax-efficient, distributing little in the way of annual capital gains. But they must be bought through a broker, so commissions are charged. (For more information on ETFs, go to www.morningstar.com, which has links to brokerage firms offering the funds.)

Another consideration for sector investors is active versus passive management. The Rydex and ProFunds sector products and various ETFs passively mimic sector stock indexes, whereas the Fidelity Select funds are actively managed. Lowell said Fidelity’s talent pool and research staff can give active management an edge.

No matter which vehicle sector investors choose, financial advisors caution that sector bets should account for only a small piece of one’s overall portfolio.

Merriman advises investors to diversify the bulk of their stock fund portfolio among large-cap and small-cap, growth and value, U.S. and international, with the remaining 15% to 20% reserved for favored sectors.

Lowell, 41, said he would cap sector plays at 15% of his total portfolio. “If I were 61, I’d keep it to 10% at most,” he added.

“Most important of all,” he said, “is picking the right sectors in the first place.”