The Best and Worst Fidelity Sector Funds

Big-name Hollywood stars like George Clooney and Julia Roberts may get a lot of the glory, but they wouldn't look so good if their movies had weak supporting casts and unskilled writers. Top-rated fund investors like Will Danoff and Joel Tillinghast aren't exactly George Clooney and Brad Pitt, but their success also depends partly on a supporting cast--in this case, Fidelity's vast analyst ranks. Both managers say they rely on the firm's analysts to surface new ideas and to help them keep up with sprawling portfolios.

That's not to downplay these managers' talents. Other Fidelity stock-pickers draw upon the same analyst research with much less impressive results. Indeed, nearly every Fidelity manager I've spoken with tells me the quantity and quality of the analysts' research provide a competitive advantage.

If heft alone guaranteed superior research, Fidelity would top just about everyone else. With more than 350 analysts globally, the size of its research operation is virtually without peer. Thanks to a mid-2000s hiring spree, the group can cover more than 2,300 companies, nearly 900 more than it did in 2006, according to Fidelity. As a result, not only is its research broader, it should be deeper too.

But is Fidelity's research any good? Fidelity's broad lineup of analyst-run sector funds provides clues. Admittedly, these funds don't tell the whole story of the firm's analytical abilities. Some analysts, such as those stationed overseas, don't have money management duties. Yet with 42 sector funds (and that's just those without loads) covering nearly every sector and industry imaginable, these funds still tell a fairly complete tale. It's one I'll attempt to unravel, while discussing the best ways to tap into Fidelity's research strengths.

The View From Above
Judging by the numbers, the quality of Fidelity's analyst ranks doesn't look too bad. As of September 2010, 64%, or 27 out 42, no-load sector funds (a group that includes all Fidelity Select funds and two real estate-focused funds) beat their category averages over the previous five-year period. More impressively, of the funds focused on the 10 broad market sectors, all ranked in their group's top quartile or better for the period. Nine of 10 outpaced their respective benchmarks, too.

In only four instances, however, was the same manager at the helm for the full five years. Indeed, the typical Fidelity sector fund manager serves just 2.8 years. Long-tenured exceptions to that rule exist, however.  Fidelity Real Estate Investment's (FRESX) Steve Buller has been around for 12 years, for example, while Charlie Chai has run Fidelity Select Communications Equipment  for more than seven. Others, including  Fidelity Select Energy's (FSENX) John Dowd and  Fidelity Select Health Care's (FSPHX) Edward Yoon, are wise beyond their tenure, boasting several years' experience covering their respective sectors before joining Fidelity. These outliers aside, though, Fidelity's diversified managers rely, by and large, on an inexperienced group for support--and many of those managers are fairly unseasoned as well. Still, there are some Fidelity sector funds worth considering.

Take a Look
Fidelity Select Health Care: I'll admit I'm taking a bit of a flier on this one. Only at the helm since February 2009, manager Eddie Yoon doesn't have a long track record. Still, Yoon has eight years under his belt investing in health-care stocks, first at J.P. Morgan and then Fidelity. He's successfully run sibling  Fidelity Select Medical Equipment/Systems (FSMEX) since 2006, too. I like that Yoon's strategy is distinctive, focusing on health services and specialty drug makers--a departure from the fund's longtime focus on big, widely owned bellwethers. And given health-care stocks' long-running underperformance, investors probably don't have to worry that they're buying in at inflated prices.

Fidelity Select Consumer Staples (FDFAX): Fidelity funds may lean toward lower-quality names, but with world-class companies like  Procter & Gamble (PG) and  Coca Cola (KO) as top holdings, this offering is a definite exception. These firms' strong competitive advantages have typically made them great long-term investments, but the valuation case for them now looks especially strong. Indeed, Morningstar equity analysts rate seven of its top 10 holdings as undervalued. Manager Bob Lee has also delivered strong results during his six years in charge, though given the high degree of overlap with ETF options like  Vanguard Consumer Staples ETF (VDC), I wouldn't expect dramatic outperformance.

Fidelity Select Energy: Manager John Dowd lets his valuation and supply/demand analysis drive where he invests. Lately, that focus has led him to behemoths like  ExxonMobil (XOM) and  Chevron (CVX), which were laggards in 2009's rally. He has previously emphasized smaller-cap fare--a tack that juiced returns in 2009 but took a toll in the 2008 downturn. Dowd's record here is mixed as a result, though I'm encouraged by his thoughtful approach, willingness to go against the grain, and his lengthy experience following the energy sector. (Before joining Fidelity in 2005, he was a senior analyst for highly regarded Sanford Bernstein for five years.)

 Fidelity Select Gold  (FSAGX): I put this fund on the recommended list with some trepidation, though not because I lack confidence in manager Joe Wickwire. Wickwire is a veteran investor in precious metals, with a long record of success at Evergreen before joining Fidelity, where he's also fared well. That said, the level of bullish sentiment swirling around gold raises concerns. Gold makes sense as insurance against inflation, a tanking U.S. dollar, or doomsday scenarios, but the precious metal requires a willingness to stick with it during lean times to make it worthwhile.

Take a Pass
 Fidelity Select Financial Services (FIDSX): This fund isn't entirely without appeal. Since taking full control in February 2009, manager Ben Hesse has differentiated his portfolio from his benchmark, scooping up Swiss and Chinese firms, for example. He's also fared well during his brief tenure at Fidelity Select Brokerage & Investment (FSLBX). I'm concerned, though, by Hesse's limited experience following financials, especially given the sector's tumultuous state. This fund has also witnessed a lot of manager turnover, and given that Hesse has been rotating through Fidelity sector funds (this is his third assignment), there's a chance he's being groomed to manage diversified portfolios. I'm not convinced he's here to stay.

 Fidelity Select Telecommunications  (FSTCX): I'm leery of this fund as a buy-and-hold investment. Rapid technological change can make it difficult for telecom firms to maintain competitive advantages. But the fund looks relatively appealing right now from a valuation standpoint. Morningstar equity research suggests holdings like  AT&T (T) and  Sprint Nextel  are highly undervalued. Manager Kristina Salen, though, is relatively new and her portfolio bears close resemblance to her benchmark as well as ETFs like  Vanguard Telecom Services ETF (VOX). Telecom's charms might be best enjoyed through a passively managed vehicle.

Fidelity Real Estate Investment: Veteran management and deep analytical resources argue in favor of this fund. Skipper Steve Buller's 12-year tenure is the longest of any Fidelity sector fund manager. Buller has the benefit of Fidelity's small-cap and credit research, an advantage many competitors don't have. Yet he's had a tough time besting the major REIT benchmarks over the past decade. If the timing were better, this fund might be a good enough way to invest in real estate. However, with REIT yields at historically low levels, it's probably not the best time to dive in.

Step Back Before Jumping In
Keep in mind that you might not need any of these funds at all. If your portfolio is well diversified, you probably have ample exposure to the sectors they track. Investing in a sector fund may mean you're doubling down on a bet you're already making. That's why it's important to consider how your portfolio is already positioned before you dive into a sector vehicle. If you're tracking your portfolio on Morningstar.com, consider using the Portfolio X-Ray feature, which provides a top-down view of how your holdings look together. If it turns out you're lightly exposed, then a sector fund might make more sense.

Moreover, don't forget that investors have had a tough time using sector funds successfully. Take Fidelity Select Medical Delivery, for instance. It's been a fairly strong performer over the past decade, up 6.5% annually for the period. Yet the fund's investor (or dollar-weighted) returns, which depicts the average investor's experience, is just 2.8%--or less than half the fund's total return. More-volatile sector funds have been even tougher to use. Fidelity Select Chemicals (FSCHX) has among the strongest returns of any sector fund in the past 10 years. Yet its 0.7% investor returns over the past 10 years are a far cry from the fund's 11.2% total return the fund earned over the period.

The reason investors don't fare as well as their funds is that they tend to buy in after a spate of good returns and sell when performance sours. They stand a better chance investing with a contrarian bent. Lagging sectors usually sell at more reasonable valuations, increasing the chances of outperformance. Investing where there's real management expertise improves the odds further. After all, managers new to their sectors will likely have a harder time getting an edge.