A Healthy Case for Sector Funds

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Editor's note: This article first appeared in the Q1 2021 issue of Morningstar magazine. Click here to subscribe.

Amid a pandemic, healthcare naturally becomes a central topic, but for financial planners, healthcare is always at the core of their thinking. As their clients age, rising health costs and longer life spans become two of the most crucial issues for a successful financial plan. I can’t recall a single financial planning conference where the topics of longevity and rising healthcare costs didn’t take center stage. The growing sophistication of treatments and the corresponding costs prompt advisors to extend the horizons of their clients’ portfolios and tilt them more heavily toward equities to meet this steep challenge.

I’ve heard many great insights from advisors into how they prepare their clients for the challenge of longer lives and higher healthcare costs, but there’s one conversation that stands out. It was at the Institute of Certified Financial Planners retreat at Yale University in the early 1990s. The conversation centered on the then-conventional practice of putting 5%-10% of a client’s portfolio in gold funds. The idea, forged in the inflationary 1970s, was that this would protect the client’s purchasing power as prices rose. It was a reasonable practice in theory, but in practice, many advisors found it difficult to implement. To make the strategy work, one had to sell off gold shares in years when they rose and step up and purchase more in years when they fell. The problem was that given gold’s volatility, the shares often spiked or crashed and were therefore either the client’s favorite or most despised part of the portfolio—and advisors had the difficult task of getting their clients to either sell what they most loved or buy what they most hated.

One advisor took exception to this strategy. She argued that her clients already had a certain level of inflation protection in their portfolios, as she routinely shifted clients to higher equity exposures than they had before working with her. She further argued that her clients weren’t worried about general inflation like the rising price of cotton or copper. What her clients were concerned about was outliving their wealth and facing growing healthcare costs as they aged.

This advisor’s solution was to ditch the gold funds and instead allocate 10% of clients’ assets to Vanguard Health Care VGHAX. She thought that the fund was likely to grow faster than the rest of her clients’ equity positions and that rebalancing would be easier than with the volatile gold funds, as the healthcare fund was apt to have an upward growth trajectory and suffer fewer sharp losses. Moreover, she noted that because her aging clients’ equity portfolios tended to skew toward income-producing value funds that were overweight in utilities, REITs, and energy stocks, her clients had diminishing positions in healthcare stocks as they aged, even though their vulnerability to rising healthcare costs increased. Her reasoning seemed sound to me, and the results have proved the merits of her approach. I suspect that her clients have been very pleased.

I was thinking about this long-ago conversation recently in the context of some internal portfolio construction conversations at Morningstar. Generally, Morningstar’s fund analysts frown on sector funds. Too often, we see money pour into them at peaks and gush out during troughs. When we first looked at dollar-weighted investor returns, we found that sector funds as a group had the largest gap between the amount of money investors actually made and what they would have made had they simply bought and held the shares. Simply put, sector funds in general tempt investors to do the wrong thing at the wrong time. But the story above illustrates that sector funds can, in the right circumstances, play an effective long-term role in a portfolio.

I think this advisor’s plan works for three main reasons. First, it has a specific purpose that matches a client need with the investment area. It’s easy to recall why you have this investment in the portfolio and, hence, to have the courage to buy more in times that the fund falls from favor. Second, the plan has a disciplined, long-term implementation strategy. The client has an advisor to encourage rebalancing, and the rebalancing happens on a predetermined annual cycle. When healthcare stocks overheat, the client sells; when they fall, the client buys more. Third, the advisor chose a low-cost, high-quality fund rather than buying individual stocks or a more narrowly defined thematic fund. Vanguard’s healthcare offering has long been one of the better-diversified and lower-cost funds of its type.

I don’t think I’ll win over all of our analysts to the side of sector fund investing, but for me, this advisor’s rational, forward-looking deployment of a sector fund showcases how advisors can intelligently match investment to investor, to invest with a specific purpose and meet specific goals. It’s the kind of creative planning that engages clients without abandoning the discipline of contrarian thinking (through rebalancing), diversification (by not using individual stocks), and keeping costs down. It’s not the theoretical perfection of buying and holding the entire market forever, but it’s something that resonates with real-world investors. To me, it’s a healthy approach to portfolio construction. After all, even Jack Bogle launched a few sector funds in his day.