Definition of Sector Fund
The sector fund is a mutual fund or exchange-traded fund that invests in one industry or one sector of the market. The aim of the sector fund is to exploit the returns of that sector. A sector is a part of the market that focuses on a specific business activity, such as healthcare or energy. For example, Bank of America belongs to the financial sector, while Target belongs to the consumer goods and services sector.
How the Sector Fund Works
Sector funds are typically used in a top-down investment approach where market sectors expected to be profitable are identified and mutual funds or ETFs representing a specific sector are purchased instead of buying individual stocks. The goal of investing in sector funds is to maximize profits amidst business cycle changes that can cause some sectors to perform better than others at times. For example, the consumer staples sector (like household goods, for example) tends to outperform and is less sensitive to fluctuations than the consumer discretionary and recreational services sector (like cars and hotels, for example) during an economic downturn. Conversely, the technology sector tends to perform better during expansion phases.
Once a desirable sector has been identified, buy shares of a related mutual fund or ETF through an investment company or broker. When you invest in a sector fund, you gain a basket of stocks representing that specific sector. These stocks represent your fractional ownership in the fund and the income it generates.
Types of Sector Funds
There are several institutions that have formally divided the market into different sectors. However, there is an industry standard known as the Global Industry Classification Standard (GICS) that enables equity analysts to assess companies’ valuations, risks, and returns, and also allows investors to easily identify and purchase funds representing a specific sector. Under GICS, established by S&P Dow Jones Indices and MSCI Inc., companies are classified into 11 sectors:
- Energy
- Materials
- Industrials
- Consumer Discretionary
- Consumer Staples
- Healthcare
- Financials
- Information Technology
- Communication Services
- Utilities
- Real Estate
The sector of any mutual fund or ETF is usually listed in the fund’s prospectus. However, you may become confused when trying to choose from among many funds in the healthcare sector. In this case, you may want to identify a subsector of that sector and then buy a fund that represents it. For example, you might choose a mutual fund that invests in healthcare companies that run nursing homes and hospitals, or an ETF that specializes in companies developing products and services aimed at discovering and treating cancer.
Advantages and Disadvantages of Sector Funds
The advantages and disadvantages of these funds include the following:
Advantages
- Avoiding the need to select individual stocks
- Increased diversification at the portfolio level
- Clearly defining core assets
Disadvantages
- Many sectors have above-average volatility
- Lack of diversification at the fund level
Explaining the Advantages
The benefits of sector funds are:
- Avoiding the need to select individual stocks: When you buy a sector fund, you get a basket of stocks representing that sector. Thus, there is no need to research and buy individual stocks, which can be time-consuming. Furthermore, companies within a specific sector typically perform similarly, allowing you to make trading decisions based on shifts in the sector rather than on changes in individual companies within that sector.
- Increased diversification at the portfolio level: Sector funds are not diversified investments in themselves as they specialize in a specific sector. However, they can be used to diversify a broader portfolio. For example, a portfolio containing an index fund, a bond fund, and a foreign stock fund can be diversified by adding small allocations of three or four sector funds.
- Clearly defining…
Basic asset clarity: With a diversified fund containing investments in all sectors of the market, you may not know exactly which companies or even sectors your investments represent. The specific focus of a sector fund and the limited number of assets make it easy to identify the sector and individual companies it invests in. This way, you can evaluate its potential as an investment for your goals and risk tolerance level.
Interpretation of the drawbacks
Sector funds are not without drawbacks:
- Many sectors have above-average volatility: For example, materials, energy, and information technology sectors tend to have above-average market volatility. While this may make it a suitable sector if you are looking for growth, it also makes you more susceptible to potential short-term losses.
- Lack of diversification at the fund level: By definition, a sector fund does not provide exposure to all sectors in the market as a diversified fund does. As a result, you may have to buy multiple sector funds to achieve the portfolio diversification that a single diversified fund could offer.
Is a sector fund worth investing in?
Investing in sectors is best suited for investors who are comfortable with wide fluctuations in value and have a long-term investment horizon that can withstand them. Of course, investors who wish to maintain their core investments can invest in sectors with below-average volatility, such as consumer goods, healthcare, and the utilities sector.
The smarter use of sector funds is to diversify a more comprehensive portfolio. Investing in funds across different sectors is optimal in this scenario, where some sectors perform well when others do not, and the low correlation between sectors can protect against losses from a significant downturn in any one sector. Conversely, this is not practical for those seeking a low-maintenance or “lazy” portfolio with just a few diversified funds representing the entire market.
Additionally, investing in sector funds is not recommended for speculative purposes. Speculative investing involves betting on stocks or funds that you think will rise in value. It is a risky gamble, as the most popular stocks today can falter within months or even days. If you want to speculate a small portion of your portfolio based on an idea you think will rise in value, it may be best to buy a sector fund containing those stocks. This way, if you are wrong about the stock, at least you will be diversified in your other investments.
Key takeaways
Sector funds focus their investments in one industry or sector.
The market has 11 standard sectors under the GICS framework.
Sector funds are used as part of a top-down investment approach.
Sector funds aim to maximize profits by leveraging changes in the business cycle.
Investing in sector funds should be suitable for investors looking for diversification and long-term investment returns.
Source: https://www.thebalancemoney.com/what-is-a-sector-fund-2466777
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