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Are Sector Funds Worth a Look?

Like any other investment, you need to know what you own and why.

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Technology stocks have done very well in recent years, and since the coronavirus pandemic, their performance has only improved. Many have surged as stay-at-home orders and an increase in telecommuting and home entertainment spurred demand for their products and services. As of Nov. 16, 2020, the Morningstar U.S. Technology Index is up 37%.

Investors who expect the tech sector to continue to outperform might be tempted to buy some major technology stocks. An alternative for those who don’t want to pick individual stocks is a tech-sector fund. Morningstar data shows that tech-sector funds have had inflows of nearly $15 billion in new investments for the year to date through October, even as equity funds overall saw outflows. The only categories more popular than the tech sector were fixed-income categories and commodities funds, which investors see as safe havens when the stocks market seems risky or is in a downturn.

Though the tech sector might not be the most attractive right now from a valuation perspective (we’ll discuss more below), sector funds can be sound investments if used thoughtfully.

Sector funds allow investors to own a particular corner of the market. For example, State Street offers 11 sector funds that focus on the 11 broad sectors that make up the S&P 500, such as energy, financials, and technology. Its Technology Select Sector SPDR ETF (XLK) is one of the biggest sector exchange-traded funds, with more than $36 billion in assets. For investors who want to focus on a specific industry, there are funds that invest at the subsector level. For example, iShares Nasdaq Biotechnology ETF (IBB) is the largest subsector fund with more than $9 billion in assets.

Watch Your Weightings
Investors can use funds like these to over- or underweight sectors and industries, in line with their own investment goals.

Before investing in a sector fund, it makes sense to first determine how much exposure you already have to that sector. It might be more than you think.

Consider a portfolio that is fully invested in the S&P 500. That diversified index still had 24% in tech as of Nov. 16, 2020, a stake much higher than the second-largest sector, healthcare, at 14%. Investors who added a tech fund on top of that might end up with much more exposure to the sector than they’d intended.

Some argue the S&P 500’s increasing technology concentration is cause for concern. High valuations in the tech sector are something to be aware of before diving in.

Think Strategically
One could instead offset the S&P 500’s tech exposure by investing in sectors that make up smaller portions of the broad index. These include basic materials, energy, or real estate, each of which comprise less than 3% of the S&P 500. Such a strategy might be driven by a desire for more dividend income, for example.

Valuation is another way to approach sector fund investing, one that reduces the price risk inherent in following popular trends such as technology today, with the caveat that value stocks may require patience. As of Nov. 9, the most undervalued sectors are energy, consumer cyclical, and real estate, which energy having by far the largest percentage of stocks with Morningstar Ratings of 4- or 5-stars, accounting for 19%.

Value investors considering a tactical play on the energy sector might consider a low-cost market-cap-weighted ETF, such as Fidelity MSCI Energy ETF (FENY) or Vanguard Energy ETF (VDE). They have Morningstar Quantitative Ratings of Silver and Gold, respectively.

Keep Your Sector Funds Allocation Small
Because of their concentrated exposure, most investors shouldn’t allocate large portions to these investments. Sector funds are safer when used as a small percentage of a well-diversified portfolio.

Sachin Nagarajan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.