Should You Invest In Sector Mutual Funds?

A sector fund is an exchange traded fund or mutual fund that concentrates its investments on a specific sector of the market (i.e. the REIT market, natural resources, the financial sector, etc). A slice or sector of the market focuses on one line of business and only includes investments that are similar to it. For example, a bank belongs in the finance sector, while a department store is classified as belonging in the customer services sector.

A sector mutual fund has three main characteristics that can be found no matter what line of business you are investing in.

1. They always focus on shares in a specific industry or line business.
2. They tend to have very concentrated holdings, since many sectors are dominated by 2 or 3 large players.
3. Sector mutual funds are usually far more volatile than more broadly-diversified funds owing to their lower levels of diversification.

Not all companies fit so neatly into sector categories, however. For example, a store can be placed in the consumer section but it can also be sub-categorized as a discount store. The auto insurance company Allstate and  Bank of America can both be found in the financial section, but their subcategories are different, because Allstate is in the insurance sector while the Bank of America is in the banking sector. Because of this, there can often be some overlap amongst the different sector funds depending on how finely-tuned their respective definitions of their target industries are.

There are many mutual fund companies that offer sector mutual funds. Fidelity and Vanguard are two of the leading companies, offering several sector funds each. It is important to note that just because you can invest in a particular sector fund doesn’t mean you should.  For example, if you’d invested heavily in the financial sector (traditionally a stable industry) over the past decade you would have been hit hard throughout the recent bear market.  The only sector fund most experts recommend individual investors own is a real estate fund with perhaps a very small allocation to a gold or natural resources fund.

If you still insist on investing in sector mutual funds despite the warnings above, try to pick a sector that will be around after the next bear market.  Consumer staples aren’t glamorous, but people will still buy toothpaste and soap long after they’ve cut back on other luxuries. As a counterexample, the technology sector was the most popular sector in early 2000, but it has become significantly less popular since then. And remember, investing in sector funds is not unlike gambling, so never devote more than a small portion of your portfolio to this strategy.