How to Pick a Solid Sector Fund

Investing in sector funds seems deceptively easy, but history has shown that investors usually make a mess of things. Many sector fund investors have lousy timing, and their choice of funds isn't all that great, either.

To understand why, it helps to begin by considering the motivations of fund companies in offering sector funds and of investors in buying them. All too often, the common denominator is greed rather than a convergence of long-term profit maximizing by the two parties.

On the one hand you have investors who read about all the good things going on in an industry. They see business is booming and long-term macro trends are supporting that growth so that it looks like the trend could last a long time. At about the same time, stocks and funds focused on that industry are putting up big returns. This triggers envy because investors wish they had been there and greed because they figure they can get rich, too, by hopping on the bandwagon. In fact, the longer a trend goes on, the greater the inflows into a sector's funds becomes.

The catch is that Wall Street is aware of all that good news and has already priced it into the prices of the stocks in the industry. In fact, Wall Street probably learned about it before you did. Let's look at a hypothetical example on a sector that's not actually hot. Say, for example, that the aging of America is expected to lead to a 50% increase in spending on pharmaceuticals over the next five years and drug companies' profits would also rise 50%. (I'm pulling these figures out of the air.) That good news would be priced into the stocks today, so that the stocks would only go up more if it turned out that profits rose by more than that 50%.

Fund companies know this, too, but they also know that they can make a fast buck by selling new or already existing sector funds to greedy investors. So, the fund companies where employees are most focused on short-term profitability typically roll out trendy sector funds. Generally, the more responsible fund companies will refrain from doing this because they know that there's a good chance the fund will do terribly and shareholders will be steamed.

So, as I said above, you have a convergence of fund companies and investors who are interested in a fast buck. We know the results aren't pretty because we've seen it happen time and again. In one study, we looked at when sector funds are rolled out and found they were a contrary indicator of a sector's prospects. Why? They launched belatedly and essentially enabled fundholders to buy high. And to make matters worse, investors--after realizing that they've been burned--subsequently sell at the worst possible time.

How to Make Sector Funds Work For You
Now that I've spelled out what can go wrong, I'll discuss how you can make things go right. There are good reasons to buy a sector fund, such as plugging a hole in your portfolio or hiring a brilliant industry specialist, and you can do just fine with them, but you have to be smarter than the lemmings I've described above.

1. Don't invest with the headlines.
If your local newspaper has an article about a great trend and the folks who made a killing in it, it's probably too late. You can see this in a sector fund's returns, too. If it has crushed the S&P 500 for two or three years running, you're too late.

2. Be patient.
If you're looking out 10 years instead of 12 months, you stand a much better chance of enjoying a good return.

3. Be early.
This is a corollary to the two rules above. Look for a sector that has been out of favor for some time and you stand a better chance of finding something ready to run.

4. Look for a manager with expertise in the sector.
The main value in choosing a sector fund is that you can sometimes get a specialist who knows the sector better than the average diversified fund manager. Therefore, you should look for a manager with a long track record in the sector and ideally a firm with that history. Most sector funds are run by third-tier managers at second-rate companies. You need to find the exception. You want funds like  JP Morgan U.S. Real Estate  and  Allianz RCM Global Technology (DRGTX), where the managers are true experts who see running a sector fund as their career goal rather than a stepping stone.

5. Don't forget about costs.
Short-term thinking and greed lead investors to ignore expenses in sector funds, yet they're just as important here as in an index fund. Many of the best sector funds charge reasonable expenses. So, rather than settle for some poor-quality fund with a 2.00% expense ratio, shop around.

6. Keep tabs on your reasons for buying a fund.
If the reasons you bought the fund (a great manager or a long-term trend) are no longer valid, you should get out. For example, a few years ago many people thought real estate--especially foreign real-estate--was going to enjoy a long and glorious boom. It turns out that was a bubble. So, at some point, investors had to accept that their thesis was wrong. If your reasoning was wrong or the great manager you liked has left, you should consider moving on.

7. Don't make them your core.
Sector funds can fill a gap or serve as a speculative play, but you should have diversified funds at the core of your portfolio. If you have a portfolio of sector funds you're likely to have left some key gaps and you'll probably be paying more in expenses than you should.