A mutual fund or exchange traded fund (ETF) whose portfolio of individual securities is concentrated in a specific sector or a smaller subdivision of a sector is known as a sector fund. These funds can be well suited to helping you achieve any of the goals for which sector investing is a solution: diversifying more broadly, making a long-term commitment to innovation, or hedging against potential losses elsewhere in your holdings.
In one example, you might simply want to add exposure to a segment of the economy that you’ve neglected for one reason or another — healthcare or consumer products perhaps. In another case, you may be concerned that a particular sector is underrepresented in your portfolio in large part because it includes newer companies without a track record to evaluate.
The convenience of choosing an actively managed sector fund rather than individual securities is that the fund staff has done the research and evaluation of potential holdings on your behalf. They also handle ongoing assessment and sell decisions if the security fails to meet expectations.
Similarly, many passively managed sector funds track indexes leased from index providers who use rigorous selective criteria for choosing index components and shed components if they are not suitable.
Sector diversification dilemma
Sector funds are structured in the same way as other funds of the same type, whether mutual or exchange traded, but they aren’t diversified in the same sense as more broadly based funds.
Each sector fund owns a number of securities, but though the actual number varies by fund, it is rarely as high as the 100 or more that’s typical of an actively managed equity mutual fund — to say nothing of the 500 or more that might be held in an index mutual fund or ETF.
Because sector funds invest not only in fewer securities but deliberately choose companies that share a number of key characteristics, including the way they respond to changes in the economy, there’s very little to protect the fund’s portfolio against a downturn. It is true that a sector fund may be less affected than a single security would be under the same conditions, but even that’s not always the case.
As a result, these funds tend to be more volatile than funds in general, moving above and below their average price both more dramatically and more quickly than is the norm. While this provides the opportunity at times for better-than-average gains it also increases the risk of higher-than-average losses if you sell your shares in a downturn.
On the other hand, sectors tend not to be correlated to the broader stock market, so a sector, such as consumer staples for example, may gain value even as the market as a whole is in a downturn. This means including one or more sector funds in your portfolio can help to improve return and reduce risk, particularly if the sectors you choose are varied as well. Of course, the reverse can also be true, with the overall market strong, and one or more sectors underperforming.
Subdivided sectors
If you’re interested in making a passive investment in a particular industry — such as medical devices companies that are part of the healthcare sector, insurance firms that are part of the financial sector, or software developers that are part of the technology sector —you can frequently find an ETF with a compatible focus.
The number of stocks included in an industry-specific index, which is typically a subset of the relevant sector index, can vary significantly, from fewer than two dozen to four dozen or more. As a result, the ETFs tracking those indexes will vary in the number of their components. While the internal diversification is something you may want to evaluate, along with which stocks are most heavily weighted in the underlying index, an industry fund still offers more risk protection than selecting a specific company within an industry.
