How to Invest in Sector Funds

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You've heard that investing in sector funds can be a smart thing to do, but how does one go about choosing the best sector funds for their portfolio? Why should investors use sector funds and when is the best time to invest in them? 

Sector funds are not for every investor. Even if you decide sector funds are a good fit for your portfolio, there is a right way and a wrong way to go about using them. Before buying into one or more of the various industrial sectors, it's a good idea to educate yourself on what they are, how they work, and how they might fit into your portfolio.

Sector Funds and How They Invest

A sector fund is a mutual fund or an exchange-traded fund (ETF) that invests most or all of its assets in one particular industrial sector. Here's a brief list of sectors that are most common, along with examples of companies these funds hold. There are many ETFs and mutual funds for every sector, and each will have a slightly different ratio of holdings. However, there are certain major companies you can expect to see in each fund that covers a specific sector.

Technology: This sector will invest in stocks of companies that produce technology products or offer technology-based services. Examples would include a software manufacturer like Microsoft (MSFT), an online retailer like Amazon (AMZN), a social media site like Facebook (FB), or a tech firm like Google parent company Alphabet (GOOG, GOOGL), which produces multiple products and services within the technology industry.

Financial: Sector funds focused on finance will hold stocks of companies like Bank of America (BAC), Charles Schwab (SCHW), and Wells Fargo (WFC). Financial stocks and financial sector funds can include more than just banks and brokerage firms—financials also include insurance companies, mutual fund companies, and financial planning firms.

Consumer Cyclical: Consumer cyclical stocks include companies like Disney (DIS), McDonald's (MCD), and Starbucks (SBUX). These are companies that sell things that people don't need for daily living. Therefore, consumer cyclical stocks tend to do better when the economy is strong and consumers are in a spending mood. That's why they're sometimes called consumer discretionary or leisure stocks.

Consumer Staples: Nearly the complete opposite of consumer cyclical stocks, companies in the consumer staples sector typically provide products and services that are needed for everyday life. Some examples of consumer staples companies include Walmart (WMT), CVS Pharmacy (CVS), and Procter & Gamble (PG). Consumer staples can also include companies that sell things that consumers don't necessarily need but will continue to buy, even if the economy slows. A worker who just suffered a pay cut isn't likely to stop drinking their favorite Coca-Cola (KO) beverage or stop using nicotine products from Philip Morris (PM).

Utilities: Companies in the utility sector provide products and services related to gas, electric, and phones. Stocks in the utility sector include Duke Energy (DUK) and Southern Company (SO). Like consumer staples, utilities will include products or services that consumers still use when times get tough. Therefore, sector funds that invest in utilities can perform better than growth-type sectors, such as technology, when a recession hits. For this reason, utilities are one of the primary defensive sectors.

Energy: The energy sector consists of all the industries involved in producing and distributing energy, including oil companies, electric companies, the coal industry, and green energy companies harnessing wind and solar power. Investors wanting concentrated exposure to big-name energy stocks, such as Exxon-Mobil (XOM) and Chevron Corp (CVX) can buy an energy sector mutual fund or ETF. Investors can also buy energy sector funds that are further specified by their emphasis on green energy production.

Natural Resources: Sector funds focused on natural resources will typically invest in commodity-based industries such as energy, chemicals, minerals, and forest products. Therefore, shareholders of these sector funds will get exposure to energy stocks like XOM and CVX, but also stocks like Newmont Mining Corp (NEM).

Health Care: Also known as health or specialty-health, this sector focuses on the health care industry, which can include hospital conglomerates, institutional services, insurance companies, drug manufacturers, biomedical companies, or medical instrument makers. Examples include Pfizer (PFE), United-Healthcare (UNH), and HCA Holdings, Inc (HCA). Health sector funds also often hold biotechnology stocks like Gilead Sciences (GILD) or Biogen (BIIB). Healthcare stocks are considered defensive holdings because they tend to hold up better than the broader market during downturns. This is because consumers still need medications and health care during recessions.

Real Estate: The real estate sector funds typically concentrate their holdings in real estate investment trusts, or REITs, which are entities that represent a collection of investors that pool their money together to purchase income-producing properties, such as office buildings and hotels. REITs are legally required to pay out at least 90% of their income to shareholders and this makes real estate sector funds attractive to investors looking for income-producing investments. Some top holdings in a real estate sector fund might include Simon Property Group (SPG) and Public Storage (PSA).

Precious Metals: This category of mutual funds would be better classified as commodities funds because precious metals aren't considered an industrial sector. Still, precious metals deserve a mention with sector funds because of its nature as an investment that concentrates its holdings into a specialized portion of capital markets. Precious metals mutual funds don't invest directly into precious metals like gold and silver. Instead, the funds invest indirectly through precious metals miners like Agnico Eagle Mines (AEM) and Newmont Mining Corp (NEM).

How to Invest in Sector Funds

Sector funds work well as diversification tools and as a possible means of increasing portfolio returns. In translation, this means that sector funds can reduce the risk for the overall portfolio while potentially maximizing returns in the long term.

A wise portfolio structure for implementing a sector funds strategy is the core and satellite portfolio structure—you begin with a core holding, which represents the largest portion of your portfolio, and then add satellite funds, which make up smaller percentages of your portfolio. For example, a good core holding is one of the best S&P 500 Index funds, which might receive an allocation of roughly 30% or 40%. The satellite holdings, which each take up a much smaller percentage of your portfolio allocation, can be small-cap funds, international stock funds, and sector funds.

When you add sector funds to the portfolio, you may want to choose a few sectors for long-term investing, a few sectors for short-term investments, or a combination of both. For example, some investors believe that technology and health are two sectors that can outperform the broader market in the coming decades. Those investors may choose to add technology sector funds and health sector funds to their portfolios, with the plan of holding onto those investments for the long-term.

An example of short-term investing with sector funds is when an investor shifts some portfolio assets in anticipation of a recession and bear market. This is called a "defensive" strategy, and defensive sectors include utilities, healthcare, and consumer staples. Note, this is not the same "defensive sector" that includes arms manufacturers and companies associated with war—those companies are part of what's known as the "aerospace and defense sector."

Cautions on Investing in Sector Funds

While there is no perfect allocation to assign each sector fund in your portfolio, a good percentage maximum to keep in mind is 5%. This may sound like a small allocation, but it is enough to add diversity to a portfolio and boost returns while minimizing risk. Therefore, if you decide to add three sector funds to your portfolio, each may receive a 5% allocation for a total sector allocation of 15%.

Investing larger amounts in sector funds can add significant risk to your portfolio. For example, biotechnology stocks, a sub-sector of health, have seen incredible short-term gains but also some large declines. If an investor bought too much of a biotech sector fund just before a big decline, it could do significant damage to the portfolio.

Also keep in mind that other mutual funds, such as your core holding, will likely provide exposure to most or all industrial sectors. Therefore, if you bought enough of a sector fund to represent 5% of your portfolio assets, your overall exposure to that sector could be much higher than 5%, due to overlapping holdings with funds you already own.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.