Sector Mutual Funds

Sector mutual funds invest in the stocks of single industries or sectors of industries, such things as commodities and precious metals, and specific types of investments such as those which are deemed to be socially responsible. They can be very broad, such as "Technology", or very narrow, such "Semiconductors."

Sector mutual funds are sometimes referred to as specialty mutual funds, which is appropriate. However, the term "specialty" can apply to more than just stock mutual funds. A good example would be commodity funds. Many commodity funds pursue their objectives by investing in securities other than stocks, which would put them in another category. So I prefer to use the term "sector" and have treated commodity funds as a separate category.

You will find sector mutual funds broken down into six to twelve sectors, depending on where you find them listed. I've listed the ten major sectors that I feel adequately cover the most popular sectors and I've added three minor sectors (Alternative Energy, Biotechnology and Green) that are relatively unique and don't fit neatly into any of the major sectors but are popular enough to be worthy of some space on this site. However, you will no doubt find other sector funds that don't fit into any of those categories, as there are nearly endless possibilities for the specialization of stock mutual funds.

Sector mutual funds serve two primary purposes. Some, such as Real Estate, Natural Resources and Precious Metals, provide diversification opportunities. Others make it possible for you to overweight your portfolio in specific industries or sectors of industries or to adjust for under-weightings attributable to the combination of funds you've assembled in your portfolio, although the need to adjust for under-weightings is not very likely.

An example of deliberate over-weighting is the decision by many people to buy Health Care funds, as they feel that health care is a sector that will do better than the general market as our population ages and because health care is fairly recession-proof, as it's largely non discretionary. So they take a small position in a health care mutual fund which results in their portfolio being over-weighted in that sector. However, before taking such an action, you should determine how it will affect your portfolio with respect to its efficiency. You should also check the management fees, as the category averages of the sector funds tend to be relatively high. The ten major sectors are:

• Energy
• Financial Services (Includes Banking.)
• Health Care
• Natural Resources (Many include Energy.)
• Precious Metals - Particularly Gold
• Real Estate
• Socially Responsible (May include Green and Alternative Energy.)
• Technology
• Telecommunications
• Utilities

Three distinct subsectors are:

• Alternative Energy (New, but growing.)
• Biotechnology
• Green (New, but growing.)

Usually, the over-weighting of any sector that is well-represented in the broader market will not lead to an optimal allocation of assets. Although you may not end up with the optimum asset allocation required for true efficiency, there's no reason you can't construct a near-optimal portfolio by making sure the assets in your portfolio work well together. Don't add sector funds just because you like them or think they may outperform the market, make sure they make a contribution to the overall efficiency of your portfolio. If you think they will outperform the market, you'll need to come up with a good estimate of their future returns and volatility to plug into the model of your portfolio if you feel their expected future performance is not reflected in their past performance.

I'm sure that some you have some very strong feelings about certain sectors and will feel compelled to add then to your portfolio regardless of how they affect its overall efficiency, and there's nothing wrong with that, you need to be happy and comfortable with your portfolio. For instance, you may want to over-weight your portfolio in Technology because you believe it's an opportunity to invest in the future and that recent past performance does not adequately reflect the sector's future. But, as I stated above, if you choose to do so, you'll need to come up with an estimate of future performance.

With the exception of the special few that are distinct asset classes that offer good diversification for your portfolio, or their use to adjust for under-weightings that may occur in the construction of your portfolio is warranted, the sector mutual funds are best reserved for making side bets with your "mad money" or "play money" outside your investing portfolio.

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