The whole issue of investing in sector funds sometimes begs more questions than it gives answers. Should you try to pick sectors, or let the managers of diversified funds do it for you?

For most investors, the short answer is—let the manager do it. Most sector funds, particularly the sector indexes, are appropriate only for traders looking to get in and get out, and not for long-term investors.

But there is one exception—which I’ll get to in a moment.

Why am I against sector investing for your long-term portfolio?

First, let’s consider returns. Looking back over long periods of time, only half of the ten major stock market sectors (the ones Vanguard’s sector funds follow) have generated market-beating returns: Those sectors are industrials, energy, financials, health care, and technology.

Industrials

Industrial sector stocks, which includes large conglomerates and manufacturers like General Electric (GE) and Boeing (BA), tend to be strongest when the economy is roaring. Yes, this sector has outperformed the broad market, but not by much. And there are plenty of times when it doesn’t outperform. So why make a concentrated bet on it?

Energy

Until a few years ago, energy stocks were severely lagging the stock market. Recently they’ve taken off (see also, “Alternative Energy: Ride the Green Wave!“).  But even though oil and gas are two commodities with fairly consistent demand, both supply and prices are anything but stable. That makes investing in this sector incredibly tricky. Many active managers layer energy stocks into their portfolios, but with discretion.

Without a better rationale for owning an energy index, rather than a diversified fund with an energy accent, I’ve got to say there are probably better places for our money, long-term.

Financials

As for financials, I could be smug and just say “Bear Stearns” with an emphasis on “bear” (see also, “Lehman Brothers (LEH) Share Price Smack Down“).
But that’s one company, not a sector. However, look what happened in 2007 after the subprime mortgage mess came to light. At the end of 2006, Vanguard’s Financials Index  had returned 19.2% for the year. But at the end of 2007, its one-year return was a negative 17.5%. What else would you expect from Wall Street but to keep their itchiest trigger fingers poised on their own industry’s button? And don’t forget that many value funds already have big weightings in financials. Do you want to add more?

That’s the return side. There’s also a risk side, and that’s where tech stock indexes hit reboot. There have just been too many…</> periods when the sector, as a whole, took long-lasting, huge dives, resulting in major losses for investors. Remember the dot-bomb implosion? I rest my case.

That leaves just one sector to consider: Health Care.

Health Care

Some people are so negative on sector investing that they immediately dismiss health care with all the rest. Vanguard’s founder Jack Bogle is a huge opponent of sector investing.

But that’s a mistake. The health “sector,” and I emphasize “sector,” represents more than 15% of GDP—hardly a small slice of our overall economy. And we’re all getting older—the population bulge is moving inexorably into its peak health care consumption years.

The health care index hasn’t been bad, yet, as with financials, tech, and energy, I’d rather let a great manager pick the best stocks in this area, and Wellington Management’s Ed Owens, who’s run Vanguard Health Care (VGHCX) since inception, is one of the best.

Ed Owens and his Wellington team are exceedingly smart, run a diversified portfolio in a very big, diverse sector and don’t make huge bets that can get them into trouble. The fund tends to be about 10% less volatile than the stock market, over time, while delivering higher returns—a win-win.

Plus, Owens and company look for opportunities overseas as well as at home. Currently, a bit less than one-third of the fund’s assets are in foreign companies. Meanwhile, Vanguard’s health care index fund doesn’t range outside our own borders.

But diversification would be useless without stellar stock-picking, and that’s the other secret weapon.

Ed Owens and his team have decimated the returns of both the MSCI Health Care index and the market. For instance, looking back to before the 2000 bear market began and calculating rolling returns for every five-year, or 60-month, period since then,  Health Care averaged a 9.9% return versus 3.8% for the health care index and 5.3% for 500 Index. The same out-performance can be seen over rolling one- and three-year periods. The result is low-volatility returns that are not highly correlated with other funds or markets.

Unfortunately, there’s just one issue investors have to deal with.  Vanguard’s Health Care fund is closed to all but Vanguard’s highest net worth investors. Fortunately, I’ve found some great alternate health care funds for everyone else.  Check out my article, “Tips on Getting Into Closed Funds“, for more information on how to access a closed fund.  Better yet, subscribe to my monthly newsletter, The Independent Adviser for Vanguard Investors, to learn about the alternative health care funds that can inoculate your portfolio now.