When to own a sector fund?

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If diversification is king. . .when do you think it's appropriate to own a sector fund like health care, alt. energy, financial, or technology?

Is it only if you own more than 5 funds?

[jIM_Ohio]

I don't look at number of funds, I would look at the following

1) amount invested already (if the amount is in a lifecycle fund which held 10 funds, then only one fund is needed).

2) the style box from the morning star xray of existing holdings (some sectors might be smaller-like tech) to verify risks already taken. I would also use the xray to make sure the managed funds or indexes I was investing in are not overweight (for example in 1997-2000 it has been noted the S&P 500 was too tech heavy and too NASDAQ heavy, so no need to add a tech fund or QQQQ to mix).

3) The desired outcome of adding the sector fund. It might be to boost returns (tech), it might be because indexes don't have it yet (alt energy), it might be to reduce volatility (utilities and natural resources or finanacials).

[humandraydel]

I agree with jim. I'd also add, however, that I would not SIGNIFICANTLY overweight a sector. I probably wouldn't overweight a sector by more than 5-10% though.

[disneysteve]

I own 2 sector funds - a healthcare fund and a gold/special minerals fund. I've owned healthcare for many years (and have enjoyed a very good track record with it - about 11% of our portfolio) and the gold fund for over a year in my wife's 403b (up just over 30% last year - unfortunately we have an insignificant amount of money in there).

When is it right to own one? I'm not quite sure. Certainly, you want to have your core portfolio in place with large caps, small caps and international at the very least (or one broadly diversified fund as Jim mentioned). After that, if you want to throw 5 or 10% into a sector bet, I think that would be fine. I'm slightly heavier into the healthcare fund, but I'm fine with that. The fund has always been a great performer and I don't see the medical field losing ground anytime soon with an aging population and ever-increasing health care expenditures.

[Broken Arrow]

I don't know if I'd go so far as Motley Fool, because I wouldn't mind overweighing the healthcare sector either.... But I do agree with them about this:

There is a simple rule for investing in stocks. Either you have the time, energy, and expertise to learn about individual companies -- their management, financials, products, and prospects -- or you don't.

...

If you're not up for that, buy a low-expense, broad market index fund. No ifs, ands, or buts.

Sector funds seem like a good idea on the surface but.... The diversification is still limited to a sector, so no matter what the diversification is, it can still perform poorly (ex. the financial sector). At the same time, I also think they're too difficult to valuate.

They're good if you have a fuzzy picture of where it's likely to go (ex. healthcare for me) but you'll still want to be very careful. Personally, the only time I would get sector-specific is if I am very confident that it's going to perform somehow.

[disneysteve]

BA - I'm not sure that speaks against sector funds as much as it speaks against individual stock picking. I don't have the time, energy and expertise to learn about individual healthcare companies. That's why I chose to put my money in a broad healthcare fund instead. The fund currently holds 79 stocks. I certainly couldn't do that kind of picking on my own.

[scfr]

Are you familiar with Scott Burns' Couch Potato Building Block Portfolios? He suggests that you start with Block One, and build from there, up to 10 blocks, depending on how diversified or complicated you want to get.

He suggests adding an Energy fund at Block 6; in other words, after the first 5 blocks are in place. That sounds pretty sensible to me.

Here's a link to an article explaining the couch potato system:

Put Sloth to Work for You - Registered Investment Advisor

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BA - I'm not sure that speaks against sector funds as much as it speaks against individual stock picking. I don't have the time, energy and expertise to learn about individual healthcare companies. That's why I chose to put my money in a broad healthcare fund instead. The fund currently holds 79 stocks. I certainly couldn't do that kind of picking on my own.

Yeah, they're a bunch of stock-happy picking Fools, aren't they?

Still, I believe there are two ways to invest safely and effectively. One is through good diversification. The other is through good research and valuations. A lot of funds out there seems to offer the best of both worlds, but I would have to politely disagree.

Naturally, diversification works best when it is spread broadly. Though it's possible to become too diversified, it can also be a hazard to overweigh your portfolio.... Sector funds lets you do just that. Sector funds are also inherently limited to certain sectors.... Again, I'm not saying that it's a bad idea, only that we have to be careful.

On the other end of the spectrum is good research and valuations. I think we can all agree that it's just not practical for us individual investors to valuate most funds.... So, the exercise works best with smaller pieces such as individual companies... stock picking.

On the surface, a lot of funds and ETFs out there seem like they're giving you the best of both worlds, but in my personal opinion, it's more like the worst of both worlds. If we agree that limited diversification and over-weighing your portfolio can be a hazard, and if we agree that it's not practical to valuate them, then I think such asset classes are often best avoided.

Hence the Motley Fool's opinion to either stick with broad diversification (of index funds) or quality research and valuations (of individual stocks), but not the muddy middle.

Again, I don't necessarily think sector funds are a bad idea either, because I would also like to over-weigh healthcare, and I'm not above sector funds. I guess all I am saying is that while it may be good enough, it is less-than-ideal. However, to answer the original question, I would most definitely not pursue sectors until broad diversification is achieved first.

[jIM_Ohio]

Yeah, they're a bunch of stock-happy picking Fools, aren't they?

Still, I believe there are two ways to invest safely and effectively. One is through good diversification. The other is through good research and valuations. A lot of funds out there seems to offer the best of both worlds, but I would have to politely disagree.

Naturally, diversification works best when it is spread broadly. Though it's possible to become too diversified, it can also be a hazard to overweigh your portfolio.... Sector funds lets you do just that. Sector funds are also inherently limited to certain sectors.... Again, I'm not saying that it's a bad idea, only that we have to be careful.

On the other end of the spectrum is good research and valuations. I think we can all agree that it's just not practical for us individual investors to valuate most funds.... So, the exercise works best with smaller pieces such as individual companies... stock picking.

On the surface, a lot of funds and ETFs out there seem like they're giving you the best of both worlds, but in my personal opinion, it's more like the worst of both worlds. If we agree that limited diversification and over-weighing your portfolio can be a hazard, and if we agree that it's not practical to valuate them, then I think such asset classes are often best avoided.

Hence the Motley Fool's opinion to either stick with broad diversification (of index funds) or quality research and valuations (of individual stocks), but not the muddy middle.

Again, I don't necessarily think sector funds are a bad idea either, because I would also like to over-weigh healthcare, and I'm not above sector funds. However, to answer the original question, I would most definitely not pursue sectors until broad diversification is achieved first.

But the opposite is also true. You can get too diversified, and that could drag performance.

First, if a person is an indexer/boglehead, I think this discussion will fall on deaf ears. Let's assume the audience is people using well diversified managed funds.

I invest expecting a given return, on average. I expect 8% on average per year. I stay quite diversified to do this.

Once I hit a larger asset base (200k invested), I actually expect higher returns (9-12% short term over 5 years). In an effort to take on more risk, I will concentrate positions. One way to do that is with sector funds.

I also know of other investors which claim to not use the 9 style boxed from morning star, but instead hold sector funds as 100% of portfolio.

Think about it:
Tech fund
Natural resources fund
Financial fund
health care fund
consumer good fund
leisure fund

and they build the portfolio that way. Disneysteve pointed out that his healthcare fund owned 79 stocks. Just guessing, but I bet the fund has around 20 large cap, 30 mid cap and 20 small cap stocks. So an investor using a 100% sector fund technique will get the style boxes covered, but the problem is solved a different way. In addition a sector fund won't have to sell the small company when it becomes a mid cap, provided the company still operates in that sector.

The bigger problem is overlap. It's possible PG is held in consumer goods, health care fund and maybe another sector not listed. It's possible GE is in tech fund, health care fund and a few others too.

If a person owns a bio tech fund, a tech fund, a health care fund and a global tech fund, it's possible again that overlap is a problem.

[pfodyssey]

I'm a big supporter of sectors or funds that can bulk up an area you are interested in investing. Examples for me include:

PRHSX (Health Sciences) - 6%
PRNEX (Natural Resources) - 11%
PRLAX (Latin America) - 6%

I view the first two as long term investments (although recent adds) and the Latin America fund to bolster my position there as my emerging markets (PRMSX) and Western Europe (PIEQX) weren't as heavy in those countries as I would like.

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But the opposite is also true. You can get too diversified, and that could drag performance.

First, if a person is an indexer/boglehead, I think this discussion will fall on deaf ears.

Well, I'm a bit busy at the moment, but real quickly, I don't think there's anything wrong with being an indexer/boglehead relative to over-diversification, because that can be achieved with index funds, actively managed funds, or a mix of both.

One can even argue that it's less likely to happen with Bogleheads since they tend to be conservative and stick to passive investing, where the pre-set asset classes already avoid over and under-diversification.

However, I do agree with the gist of your response, which is what I was referring with in terms of over-weighing.

edit: A bit more time. I don't disagree that you can diversify via sectors. No argument at all, in fact. However, unless I am mistaken, I don't think that was the original question. I believe the original question was to use a sector mutual fund to over-weigh something that one believes will trend up. It's one thing to passively diversify via sectors. It's another to over-weigh as an active position.

[jIM_Ohio]

Well, I'm a bit busy at the moment, but real quickly, I don't think there's anything wrong with being an indexer/boglehead relative to over-diversification, because that can be achieved with index funds, actively managed funds, or a mix of both.

One can even argue that it's less likely to happen with Bogleheads since they tend to be conservative and stick to passive investing, where the pre-set asset classes already avoid over and under-diversification.

However, I do agree with the gist of your response, which is what I was referring with in terms of over-weighing.

edit: A bit more time. I don't disagree that you can diversify via sectors. No argument at all, in fact. However, unless I am mistaken, I don't think that was the original question. I believe the original question was to use a sector mutual fund to over-weigh something that one believes will trend up. It's one thing to passively diversify via sectors. It's another to over-weigh as an active position.

My point was an indexer- if they truly believe the financial porn they read- then anything similar to a sector fund is against everything indexing hopes to achieve. Indexing means take on the risk of the market because that is the maximum risk that can be taken or something to that effect for long term, and if any sector outperformed long term, everyone would be investing in it already.

I don't subscribe to that at all.

An indexer won't ever be "over diversified"- they will be as diversified as the market it (if the sector is in the index with a given weighting, then that is max risk to take in that sector).

So being overdiversified will be less common with a boglehead- that was my point- because the market in and of itself is diversified.

Overweighting (concentrating) as an active position makes sense. For me it's a 5 year run. I want 5 years in that sector with around 12% annual returns to show from it- for that position. The rest of my diversified portfolio might be 8% returns over same period.

This is because if I take on more risk, I expect a higher reward. I would prefer that risks be willing to accept volatility, but in the end that volatility should reward me with higher returns.

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Aw, come on Jim.... Are indexers really that blasphemous? Because, as much as I hate to have to point it out, to describe any particular group as "deaf" and "pornographic" simply because they run contrary to your beliefs seem like... trolling. Nor is there any productive value to be gained by engaging in this tangent. So... you've got me stumped about what to say... other than to ignore it....

As for the debate regarding sector fund itself, well, is there one? It seems like we agree....

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Now, you see, I find that fascinating - as you accumulate more wealth, you take on more risk.

I would rather overplay a sector when I am at 5 figures in assets than when I am at 6 figures.

I figure, okay. . .if I put 20-30K into a sector and I have a portfolio of about 90K. . .what's the worst that can happen? 2 years of -20% returns?. . .that's about a $12,000 loss.

Now. . .let's say I have a portfolio of 500K.

I put 100K into a sector. . .and now I get 2 years of -20% returns. . .well. . .that's about $36,000 in losses. My 100K is now worth 64K. I have some explaining to do to the DW. ("Um, honey. . .we have to talk about our latest statement from Janus. . ." LOL)

There's something psychological about that (although not entirely beyond my risk tolerance).

[Scanner]

BTW, all jabbing aside (and I think a few jabs are fair ball), I do respect what you guys write. You may not think it sinks through but trust me, what you write does sink in with me.

I see a little of myself in JimOhio, sweeps, b.a., disneysteve, etc. We are all different but probably have more overlap than we think.

One thing I wanted to write was DisneySteve said he didn't have much in his precious metal fund.

You see. . .I think that's what JimOhio and I kind of allude to about playing sectors, etc.

If you are going to make a play. . .make a play. . .I mean, what's the point of putting 5% of your portfolio somewhere unless you get some extreme leverage (like options or futures)?

I don't pretend to know what DisneySteve did. . .I know he has a 6 figure portfolio but if he only put 10-20K there. . .big deal, he's made 5-10K for a lot of risk.

This is what I think what JimOhio means by being overdiversified dragging performance.