"What do you think of sector funds?" a reader asks.
It's a simple question, but it warrants more than a simple answer because of the differences in the funds' investment policies and, therefore, in their suitability for different investors.
Sector funds are equity mutual funds whose portfolios are concentrated in a single industry or economic sector, whether in manufacturing (such as autos and drugs), services (such as banking and utilities), or mining (gold). Their investment objective is capital appreciation, but some may pay dividends.
Although the diversification of their portfolios among companies may reduce the risks associated with investment in any single firm -- a major reason for using any mutual fund -- their concentration makes them vulnerable to the risks associated with the particular sector.
Of course, their concentration also may enable them to earn above-average returns if a sector's stocks are performing better than the broad market.
In 1991, a terrific year for the stock market generally, a sector fund, Oppenheimer Global Bio-Tech Fund, led all funds with a total return of 121.1 percent -- roughly four times that of the general market, as measured by the Standard & Poor's 500 Index. Even the health and biotechnology sector's bottom fund had a 42 percent return.
And in this year's first quarter, when the market was off slightly, it was a sector fund, Fidelity Select Automotive Portfolio, that led with a 24.6 percent return.
But not all sector funds outperform the S&P 500. Each year, some subject their shareholders to sharp drops.
Sector funds have been around for a long time. Some, such as Century Shares Trust, which invests in insurance and banking shares, go back to the 1920s. But it was in the bull market of the 1980s that they really began to flourish.
That can be attributed in no small measure to Fidelity's Select Portfolios. Fidelity began with six in 1981 and added others periodically until there are now 35. They range in net assets from $2 million or less for Defense and Aerospace, Industrial Technology and Transportation to $1.1 billion for Biotechnology and Health Care.
In 1984, Financial Funds started the first five of its eight sector funds and the Vanguard Group offered its five Specialized Portfolios. A sixth, Utilities Income, is to be added soon.
Lipper Analytical Services tracks 168 sector funds in all. It has created eight classifications for 139 and assigned another 29 -- several of them the only funds for particular sectors -- to a specialty/miscellaneous category.
Which, if any, of these funds is right for you depends on your investment objective and risk tolerance, on whether you want a more or less volatile fund, one in a mature or an emerging industry, one that pays a dividend or one that doesn't.
If you own a few diversified equity funds and want to enhance your appreciation prospects, you might wish to add a fund in a sector that you believe will enjoy above-average growth. But if you have no diversified equity fund at all, it would be prudent to resist the temptation because of the potential risk and first establish a core position in a suitable general fund.
Although many sector fund shareholders are long-term investors, others switch funds after short periods. Fund managements have the impression that a number of switchers have been losing money.
As John C. Bogle, Vanguard chairman, wrote in the latest annual report for Vanguard specialized portfolios: "Some investors have exhibited, over time, a propensity to switch back and forth between these types of investments 'on a wing and a prayer,' often selling their shares just as a particular industry takes a turn for the better, and buying shares when a particular sector strategy has reached its zenith."
Imprudent, frequent trading doesn't only have an investment impact (as well as income tax consequences) for the investors who engage in it.
Fund transaction costs resulting from their trading also can hurt the returns of investors who stay in. And, of course, sudden inflows and outflows of cash cause difficulties for the portfolio managers, especially when they have to sell attractive stocks to accommodate redemptions.
To discourage such activity, Fidelity imposed in 1990 a 0.75 percent fee for redemption of shares held less than 30 days.
Vanguard has a 1 percent redemption fee (which goes into the funds). Financial Funds charges no fee but limits shareholders of its Strategic Portfolios to four "round trips" a year.
Best and worst performing sector funds
.. .. .. .. .. .. .. .. .. .. .. .. ..Total
Year.. .. ..Best Performer.. .. .. ..return
1982.. .. ..U.S. Gold.. .. .. .. .. .. 72.4%
1983.. .. ..Fidelity Select Tech.. .. .52.5%
1984.. .. ..Prudential Utility.. .. .. 38.6%
1985.. .. ..Fidelity Select Health.. ..59.4%
1986.. .. ..USAA Gold.. .. .. .. .. .. 55.6%
1987.. .. ..Oppenheimer Gold&Spec.M.. .71.6%
1988.. .. ..Fidelity Sel. Retailing.. .38.7%
1989.. .. ..U.S. Gold.. .. .. .. .. .. 64.7%
1990.. .. ..Fidelity Sel. Biotech.. .. 44.4%