The ultimate goal of smart portfolio management is to maximize returns while minimizing risk. Sector funds accomplish this … If you know what you’re doing.
Part of the confusion is that there may be just as many industrial sectors as there are strategies for investing in them. Depending on the source, there are at least a dozen classifications for sector funds.
The primary sectors are healthcare, financials, energy, real estate, technology, utilities, consumer cyclical and consumer non-discretionary.
Then there are sub-sectors, like biotechnology and energy limited partnership. And some investors and money managers consider precious metals (e.g. gold) and broad-basket commodities as sectors.
Choosing the Best Sector Funds for Your Portfolio
As with any other investment security type, there is no way of knowing for sure which sector is going to be the next hit in the market. Even the best active fund managers don’t expect to find hot sectors at the moment of takeoff and sell before a crash.
The selection criteria for any given portfolio will be primarily based upon the objective of the portfolio — be it growth or income.
Do you want to try your hand at picking the growing sectors of the coming quarter, year or decade? Or are you convinced the market is about to tank and you want to add exposure to the best defensive sector funds? Your call.
At any rate, these are generally the best sectors matched to a few basic investment objectives (using the SPDR sector and industry ETFs as proxies):
- Best Sectors for Growth: Technology (XLK), healthcare (XLV) — especially biotechnology (XBI) — and consumer staples (XLP)
- Best Sectors for Dividends: Financials (XLF), real estate (RWX), utilities (XLU) and energy (XLE)
- Best Defensive Sectors: Healthcare, utilities and precious metals (XME)
The number of sector funds to buy and hold will also depend on the portfolio objective, but it is generally a good idea to buy more than one sector fund and to keep exposure to a minimum.
How to Balance Risk and Reward With Sector Funds
Professional money managers will typically look to pick securities within sectors set to outperform in the near-term. But to maximize returns while minimizing risk, the best managers won’t weight their portfolios completely to one or two sectors, and they won’t expect to be “right” about each sector.
For example, the manager of an actively managed large-cap fund may build a portfolio with stocks in the S&P 500 index, but will often allocate more assets to a few chosen sectors that they believe can outperform the S&P 500 over the next one to five years.
To mimic this in an individual portfolio, an investor can implement what is called a core-and-satellite structure. Just as it sounds, core-and-satellite will allocate a majority of assets to a broad market index (the core), such as the S&P 500, and then add satellites with smaller allocations.
This is where sector funds come into play.
Portfolio Example and Strategy Using Sector Funds
To build a core-and-satellite portfolio with sector funds, with the objective of juicing returns while minimizing risk through diversification, an investor can start with traditional fund types, including a large-cap index fund, an international stock fund, a small-cap stock fund and a bond fund, then add a few sector funds to the mix.
Here’s an example of what a moderate to moderately aggressive core-and-satellite portfolio with a long-term objective might look like:
- 30% S&P 500 index fund
- 15% international stock
- 10% small-cap stock
- 30% total bond index fund
- 15% sector funds
To be more specific on the sector funds, an investor might choose three sectors and allocate 5% to each, for a total of 15% allocation. But which sectors are the best?
This goes back to the investor’s specific objective but for timing purposes, a good strategy is to pick one sector that looks to outperform over the next 12 months, a second that will likely outperform on average over the next three years and a third that might do well over the next 10 years.
As I write this, for instance, the economy is in the latter stages of its cycle, where interest rates are rising and growth tends to outperform value. In this case, a technology sector fund could work well. If the investor wanted to look ahead to the next bear market, they may add utilities or consumer non-discretionary to the mix as the second choice. For a long-term sector (and one that can do well in the short term or as a defensive move), a good choice is healthcare.
At least two of the three sectors will, hopefully, significantly outperform the S&P 500 over the investor’s holding period. When employing the strategy of adding sector funds to a diversified portfolio, and using small but meaningful allocation percentages, an investor can enhance returns for the portfolio as a whole while reducing risk.
As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities. His No. 1 holding is his privately held investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent a recommendation to buy or sell securities.
