Sector funds can be useful tools, but because they are not diversified investments, they tend to be more volatile than the broad market. We advocate that they make up, at the most, between five to ten percent of your portfolio. However, they may not be appropriate for all investors. Here are some pros and cons of sector funds to consider:
Sector fund pros
- Sector funds can provide diversification to a portfolio. If, for example, an analysis of your portfolio shows that you have very little exposure to health care stocks, then a health care sector fund can fill that gap and further diversify your portfolio.
- Speculative investors may look to sector funds as a way to make a big profit over a short period of time. This can be risky as the potential for gains might be offset by the potential of losses and value over a short period of time.
Sector fund cons
- Sector funds are very concentrated in nature and therefore tend to be more volatile than their diversified counterparts that invest across sectors. While sector funds tend to hold several securities in their portfolios, the holdings are all very similar and tend to move in the same direction. When a sector of the market performs poorly, funds that invest in that sector will also perform poorly.
- Investors should be wary of sector fund fees. While the published expense ratio of many sector funds may be reasonable compared to more diversified funds, some sector funds have very high turnover. This means that the portfolio manager is frequently buying and selling securities for the portfolio. Frequent trading generates commission costs, which detract from the portfolio’s returns. Additionally, frequent trading may increase the investor’s tax burden.
How to use sector funds
It is best to build a portfolio with diversified mutual funds. These funds provide broader exposure than sector funds, which mitigates volatility and risk. A portfolio that is built properly usually does not need to include any sector funds. If, however, your portfolio is underweight in a certain sector, adding a sector fund to your portfolio can help balance it out. For example, if many of the diversified funds in your portfolio tend to avoid technology stocks, a technology sector fund could be a good complement to your portfolio.
Before investing in a sector fund, you should look closely at the fund’s holdings and at the holdings in your current portfolio. You may find that you already hold several of the sector fund’s holdings in your current portfolio. For example, Microsoft could be a large holding in a technology sector fund, but it may also be a large holding in a more diversified large-cap fund that you already hold in your portfolio.
What to do next
- Seek advice from an investment advisor.
- Compare a sector fund’s holdings with the holdings in your current portfolio.
- Decide what funds are right for your portfolio.