Sector Funds: Investing in the
Economy "By the Slice"
Indexes like the S&P 500 and Wilshire 5000 include the stocks of companies from every industry and segment of our economy. Mutual funds that track these benchmarks ("index funds") offer broad diversification that lowers risk and assures that their shareholders will participate in the overall strength of the U.S. economy.
Some investors, however, wish to target a portion of their investing toward specific industries. To do this, they rely on "sector" funds. These are special purpose stock funds that limit their investing to a specific segment of the marketplace. Rather than gaining broad diversification, which is one of the main reasons for investing in mutual funds, investors in sector funds are buying into a non-diversified portfolio that restricts its reach to a particular industry or investing theme. When their particular industry is in favor, such funds really shine. But they have greater risk than regular stock funds because when tough times hit the companies in the industry in which the fund specializes, the fund manager can't switch into something else.
The most popular kinds of sector funds include such specialized investing themes as communications, financial services, health care, natural resources, precious metals, real estate, technology, and utilities. Due to their occasionally eye-popping results, sector funds continue to grow in popularity and had more than $225 billion in assets at last reporting. Because of their lack of flexibility, however, sector funds generally carry higher risk. To put their risk and performance into perspective, I've created graphs for six of the sector categories. The columns show each category's rolling twelve-month returns over the past 20 years (this is an average—individual funds will vary). They give you a quick visual guide to the volatility of each group and how often shareholders lost money over a twelve-month period. The average annual return for the past 20 years is provided under each heading as well as our risk assessment. For example, a reading of "53% greater" such as that shown for the communications category means that those funds, as a group, have been 53% more volatile than the S&P 500 index over the past ten years.
Due to the generally higher risk, I usually suggest that only experienced investors should consider sector funds for inclusion in their portfolios. For SMI web members, we offer an optional sector fund recommendation on our Advanced Strategies 
page. Those recommendations have returned, on average, 31.7% annually — before transaction costs — over the past 15 years. For data on individual sector funds, see pages 17-18 in our monthly Fund Performance Rankings . 
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