What Is a Sector Fund?

Definition and Basics of Sector Funds

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A sector fund is a mutual fund or exchange-traded fund that concentrates its investments in a single sector of the market. A sector is a slice of the market that is focused on the same line of business. For example, Bank of America is in the financial services sector, while Wal-Mart is in the consumer services sector.

But how can investors use sector funds to their advantage? Are sector funds suitable investment types for all investors? Here's what you need to know before investing in sectors:

Common Characteristics and Examples of Sector Funds

There are three characteristics that are common among sector funds:

  1. Focused on stocks within a certain business or industry
  2. Concentrated number of holdings
  3. More volatile than the overall stock market

In different words, sectors of the market are concentrated sections that are focused on similar industries. Some of the primary sectors include technology, healthcare, utilities, and financials.

How Many Sectors Are There for Sector Funds?

There are several organizations which have formally divided the market into various sectors and subsets of sectors. Wal-Mart is in the consumer services sector, but it can be further categorized as a discount store. Bank of America and Allstate are both in the financial services sector, but upon further categorizing, Bank of America is in the banking sector while Allstate is in the insurance sector. You can invest in most of these sectors through a mutual fund or exchange-traded fund.

Here are sectors, as categorized by Morningstar, Inc, a widely-recognized mutual fund research company:

  1. Technology
  2. Financials
  3. Consumer Cyclical
  4. Consumer Staples
  5. Utilities
  6. Natural Resources
  7. Healthcare
  8. Real Estate
  9. Precious Metals

Although Morningstar’s eight sectors are helpful in categorizing sector funds, the trend has been to identify an increasing number of sectors and create products (mutual funds, exchange-traded funds, etc.) based on those sectors. Your head might spin when you’re trying to pick a fund in the healthcare sector. In that case, you might run across a fund focused on identifying companies that develop products and services that detect and treat cancer. You can also buy a fund that focuses on investing in companies that manage nursing homes and hospitals.

Should You Invest in a Sector Fund?

Should you invest in a sector fund? It depends. Do you want to try picking the hottest sector of the next decade? In 1999, the technology sector was all the rage until it stumbled in March 2000. Tech stocks took several years to recover from those losses but they found themselves back in favor when the Internet, mobile technologies and social media became part of the fabric of society and industry with companies like Apple, Google and Facebook.

Therefore if you are comfortable with wide fluctuations in value and you have a long-term perspective, technology sector funds could be a smart choice for you. But there are also sectors that are quite as volatile, such as utilities and healthcare.

Perhaps the smartest purpose of sector funds is for diversification. In this case a portfolio of mutual funds that includes an S&P 500 Index fund, a bond fund, and a foreign stock fund, could be further diversified by adding small allocations of three or four sectors funds.

But 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 speculators generally try to make huge profits in a very short period. Although I am not a fan of speculative investing, if you want to speculate with a small 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 the stock. That way, if you’re wrong about the stock, at least you are diversified among your other holdings.