Learn how a sector fund works, its pros and cons, and the various types of funds to decide if buying one is right for your investment strategy.
What Is a Sector Fund?
A sector fund is an ETF or mutual fund that limits its holdings to companies in a particular industry or sector of the market to capitalize on the returns of that sector. A sector is a slice of the market that focuses on a particular line of business like health care or energy. For example, Bank of America is in the financial sector, and Target is in the discretionary consumer goods and services sector.
A key distinction between mutual funds and ETFs is that the latter is traded on a national stock exchange—that too, at prices that don't necessarily match the net asset value (NAV) of the shares.
How a Sector Fund Works
A sector fund is usually used in a top-down investment approach whereby you single out the market sectors that are expected to be profitable and buy mutual funds or ETFs with holdings in a basket of stocks representing a particular sector instead of buying individual stocks. The goal of investing in sector funds is to maximize profits amidst shifts in the business cycle that can cause certain sectors to perform better than others at certain times. For example, the consumer staples sector (household goods, for example) tends to outperform and is less sensitive to volatility than the discretionary consumer goods and services sector (cars and hotels, for example) during economic contractions. In contrast, information technology tends to fare better during the expansion phase.
Once you've identified a desirable sector, buy shares of a relevant sector mutual or ETF through an investment firm or brokerage. When you invest in a sector fund, you acquire a basket of stocks representing that particular sector. Such shares represent your partial ownership in the fund and the income it produces.
For example, let's say that the economy is in the throes of a recession, and you're looking for a sector fund that can help minimize losses during the expected market downturn. You might identify consumer staples as a recession-proof sector. As such, you might choose a sector fund like The Consumer Staples Select Sector SPDR Fund, an index fund that seeks to track the returns of the Consumer Staples Select Sector Index by investing in companies that specialize in the beverage, food, and household product and personal product industries in the U.S. This strategy is reflected in its top five holdings: Proctor & Gamble Company, PepsiCo Inc., Walmart Inc., Coca-Cola Company, and Mondelez International Inc.
Types of Sector Funds
There are several organizations that have formally divided the market into various sectors. But an industry standard known as the Global International Classification Standard (GICS) allows stock analysts to assess the valuation of companies and their risks and returns; it also enables investors to more easily select and purchase funds representing a given sector. Under the GICS, developed by the S&P Down Jones Indices and MSCI Inc., companies are classified into 11 sectors:
- Consumer discretionary
- Consumer staples
- Health care
- Information technology
- Communication services
- Real estate
The sector of any given mutual fund or ETF is usually listed in the fund prospectus. Even so, your head might spin when you attempt to pick from among the numerous funds in the health-care sector. In that case, you might want to identify a sub-sector of that sector and then buy a fund that represents it. For example, you might choose a mutual fund invested in health-care firms that manage nursing homes and hospitals, or an ETF specializing in firms that develop products and services that aim to detect and treat cancer.
If you're having trouble picking a fund in your chosen sector, narrow your focus to an individual sub-sector of that sector.
Pros and Cons of Sector Funds
The advantages and drawbacks of these funds include:
Avoid the need for individual stock picks
Increase portfolio-level diversification
Clearly identify underlying holdings
Many sectors have above-average volatility
Lack of fund-level diversification
The benefits of sector funds are that they:
- Avoid the need for individual stock picks: When you buy a sector fund, you acquire a basket of stocks representing that sector. As such, there's no need to research and purchase individual company stocks, which can be time-consuming. Moreover, companies that belong to a given sector usually perform similarly, so you can make trading decisions based on shifts in a sector as opposed to the changing dynamics of all the individual companies within that sector.
- Increase portfolio-level diversification: Sector funds aren't in and of themselves diversified investments as they specialize in a particular sector. But they can be used to diversify a broad portfolio. For example, a portfolio with an index fund, a bond fund, and a foreign stock fund could be further diversified by adding small allocations of three or four sector funds.
- Clearly identify underlying holdings: With a diversified fund with holdings in all market sectors, you may not know exactly which companies or even sectors your holdings represent. A sector fund's targeted focus and limited number of holdings make it easier to identify both the sector and the individual firms it invests in. This way, you can better assess its potential as an investment for your individual goals and risk tolerance.
Sector funds aren't without their drawbacks:
- Many sectors have above-average volatility: For example, materials, energy, and information technology tend to have above-average volatility for the market. While that might make them a suitable sector if you seek growth, they also make you more vulnerable to potential losses in the short term.
- Lack of fund-level diversification: By definition, a sector fund doesn't offer exposure to all sectors in the market as a diversified fund does. As a result, you might have to buy multiple sector funds to achieve the portfolio diversification that a single diversified fund might avail.
Is a Sector Fund Worth It?
Sector investing is most suitable for investors who are comfortable with potentially wide fluctuations in value and have a long-term investment horizon that can weather them. Of course, investors who want to preserve their principal investment can invest in sectors with below-average volatility, such as the consumer staples, health care, and utility sectors.
The smartest use of sector funds is for diversification of a more broad portfolio. Investing in funds in different sectors is ideal in this scenario, as certain sectors perform well when others don't, and a low correlation between sectors can hedge against losses from large downswings in any one sector. In contrast, they're not as practical for someone seeking a low-maintenance or "lazy" portfolio" with a few diversified funds that collectively represent the entire market.
In addition, investing in sector funds for speculative purposes is not advised. Speculative investing entails placing bets on stocks or funds that you think will soar in value. It’s a risky proposition, as the hottest stock today might stumble within months or even days. If you must speculate with a minuscule portion of your portfolio based on a hunch you have about a particular stock, you might be better off buying the sector fund that holds that stock. That way, if you’re wrong about the stock, at least you're diversified in your other holdings.
- A sector fund concentrates its investment in an industry or sector.
- Under the GICS, there are 11 standard sectors.
- These funds are used as a part of a top-down investing approach where the investor identifies a profitable sector and buys shares of a sector mutual fund or ETF representing that sector.
- This type of funds avoids the need to buy individual stocks, but many sectors have above-average volatility that investors should weigh against their projected returns.