In What is a core holding, we explained why sector funds must never be core holdings. These funds should never corner the bulk of your portfolio and are the stop-and-go investments that may juice returns.
They could make an appearance in your portfolio as they allow for the possibility of extraordinary returns. Of course, they also generally carry a higher level of risk, but as long as you limit the more risky portion of your portfolio, you aren't in any great danger.
An issue with sector funds is that investors rarely act on a well thought out strategy. They simply gravitate towards the flavour of the year, which means that they are already behind. A financial planner noted that people who invest in today’s winners are “buying backward”.
For instance, energy funds (Morningstar category: Sector – Energy), put up a stellar performance in 2007 with a return of 105% that year. Investors piled onto funds in the sector. The next year the category average was -53%. No doubt, the mayhem that year hit every single sector. While it bounced back the next year, its returns in 2010, 2011 and 2013 were abysmal. Last year it made a comeback with a return of 47%, but still a far cry from its 2007 feat.
Or, take a look at financial services (Morningstar category: Sector – Financial Services). For three years it kept sliding: 76% (2009) to 29% (2010) and -33% (2011). It picked up in 2012 to deliver a category average of 56% but once again dipped in 2013 to again pick up in 2014.
An essential characteristic of sector funds is that they can shoot out the lights one year and be a loser the next because they essentially lack the diversification to ride out trouble. One should never commit the grave error of investing in a sector fund simply because it has had a great run that year. Unlike a regular equity diversified fund, the fund manager does not have much latitude if the sector falls from favour.
Could you do without them entirely?
John Bogle, the founder of Vanguard funds, believes you can. He is known to have said: "You could go your entire life without ever owning a sector fund and probably never miss it." Bogle's point is simply that a well-diversified portfolio doesn't need sector funds.
Sector funds concentrate their investments in a single sector, such as FMCG, financial services, healthcare, and technology. These are sectors which an investor would find represented in a diversified equity fund.
By and large, buy-and-hold investors should steer clear of sector funds altogether, because not only are they betting on a single sector, but they are betting heavily on a few companies.
On the other hand, sector funds can be useful tools for investors with strong views who want to give a tactical slant to their portfolio. In areas of the market you are confident about or see an upturn in the future, you can employ a sector strategy to increase exposure. But if you invest in them, you need to understand exactly what you’re buying — and how much risk is involved.
Before you invest in a sector fund, you should be in a position to articulate your stance on why you believe that sector is likely to outperform, and what your criteria are for exiting it.
It’s always tempting to jump into sectors when they are hot. And sector funds will be able to deliver some stupendous returns on and off, giving your portfolio the muscle to outperform the market. Yet don’t lose sight of the fact that they can also log some dizzy falls. Instead, decide on your sector allocation based on your risk capacity, not on how well that particular sector is doing.
Finally, when you invest in a sector funds, you should be geared to take a hit. After all, you may get your call wrong. Alternatively, when the relevant sector is on a roll, don’t be afraid to leave potential gains on the table. Staying on in the hope that the sector will keep sizzling could backfire. And, as long as you are invested, don’t let hair-raising volatility disturb you or prevent you from sticking to your investment strategy.
Follow these guidelines when investing in sector funds:
- They must corner a very small portion of your portfolio.
- They must never be a core holding.
- Don’t be afraid to take losses. You will lose if your call is wrong.
- On the other hand, if you have earned substantially well, walk away. Don’t get upset about leaving potential gains on the table.
- Volatility is a given; don’t let it shake you. Have a clear investment strategy as to why you want to invest in that sector and stick to it.
