Sometimes just a few stocks dominate these portfolios.
Sector funds have been around for decades. But in recent years the explosion in the number of exchange-traded funds has widened the range of options in this field. For investors seeking to fine-tune their allocations after the 2008 financial-system meltdown, such niche offerings, whether in ETF or mutual fund format, can be tempting choices.
Although investors can easily build suitable investment plans without narrowly focused portfolios, sector funds can serve a purpose. Some are useful for short-term traders (ETFs often play that role), while certain sector funds in the mutual fund format have developed into impressive long-term options. Whatever the reason that investors might be looking at sector funds, though, it's important to know what these funds own. Some are so concentrated they may give you second thoughts.
Readers may wonder why that would be a problem. Isn't concentration the purpose of a sector fund? Only in part. Yes, by their nature, these types of funds will not provide broad market exposure. But investors choose a sector fund hoping it will reflect the fortunes of an area they think has a bright future. This faith must go beyond a specific company or two. Otherwise, it would make more sense to simply buy the stocks.
Some sector funds, though, have a tremendous amount of their assets packed into their top holdings. A portfolio constructed in this manner becomes less an investment based on a broad industry theme and more of a play on a tiny number of companies. If one stock falters, shareholders may not get the result they'd hoped for even if the sector as a whole shines.
Mega-Phone Stakes in Communications Funds
Investors who want to bet on the telecom sector have a variety of funds to choose from. But tread carefully: It's not unusual to see extraordinary concentration in their top holdings. Fidelity Select Telecommunications FSTCX is a case in point. As of the end of January 2012, the fund had 21% of its assets in AT&T T and another 14% in Verizon Communications VZ. That's more than a third of the fund riding on two companies. Add in CenturyLink CTL and the total rises to 44%.
If the telecom field soars, though, wouldn't those stocks join the party? Well, they should. Or, given their prominence, they could even set the sector's course. But that's not guaranteed. Something can always go wrong with one company that has nothing to do with the wider currents in its field. If one of those top holdings had a serious setback, a shareholder in the fund likely wouldn't participate nearly as much in a sector rally as hoped--especially if the afflicted stock is AT&T.
One might think that Putnam Global Communication PGBZX would be less prone to concentration at the top, given the larger universe of stocks implied in its name. But as of year-end 2011, it had 17% of assets in Vodafone VOD, 15% in AT&T, and 14% in Verizon. That makes 46% of assets in only three stocks.
Besides the risk of a company-specific problem hitting one of the heavily weighted stocks, when funds have such huge stakes at the top there's the chance of significant overlap with an investor's other offerings. After all, these companies are present in the portfolios of many big, diversified core-type funds. At the $12.6 billion T. Rowe Price Value TRVLX, for example, AT&T is the fourth-largest holding, with more than 2% of assets.