Mutual funds can offer a simplified approach to portfolio diversification. When you buy a mutual fund or exchange-traded fund (ETF), you can own a collection of investments rather than having to purchase individual stocks. Sector funds are a type of mutual fund or ETF that targets individual market sectors or industries. These funds are a more specialized option for investors who want to gain exposure to a specific grouping of companies or areas of the economy. Investing in sector funds starts with understanding how they work and what they can add to your portfolio.
A financial advisor can help you create a financial plan for your investment needs and goals.
Market Sectors Defined
A good way to understand market sectors is to think of the stock market as a pie with 11 slices. Each slice of the pie represents a different market sector, which is focused on a particular industry or segment of the economy. Currently, the stock market is divided into the 11 sectors below:
- Consumer Discretionary
- Consumer Staples
- Energy
- Healthcare
- Financials
- Industrials
- Information Technology
- Materials
- Real Estate
- Telecommunication Services
- Utilities
These sectors can be further divided into industry groups, industries and sub-industries. Dividing industries this way can make it easier to compare performance across different parts of the economy as well as measuring trends over time. For example, stock analysts may use trading activity in the tech sector as a benchmark for gauging which way a stock index may move.
Sector Funds Explained
Sector funds are mutual funds and ETFs that focus on a specific stock market sector. For example, you may invest in healthcare sector funds that only own healthcare stocks. Or you might buy a financial sector ETF that only invests in banks and other financial institutions.
Sector funds essentially allow you to capitalize on the projected growth of a market sector in a streamlined way. For example, instead of shelling out thousands of dollars to purchase individual shares of Amazon (AMZN) or Facebook (FB), you could buy a single sector fund that owns those and other tech giant stocks. Assuming the underlying companies in the fund continue to perform well, you could reap the benefits if you’re able to sell the fund later at a gain.
Investing in one or more sector funds can help to diversify your portfolio while minimizing risk. But more importantly, it could help with fueling growth if you’re targeting sectors and sector funds that outpace the market. That makes sector funds more of an active investment strategy, since you may need to spend more time studying and researching sector performance and fund make-up.
Offensive vs. Defensive Sector Funds
Sector funds are often categorized based on how they perform in relation to stock market movements and trends. Offensive sectors and their corresponding funds tend to perform well when the market is up. Defensive sector funds, on the other hand, tend do better when the market is down. Another way to frame this is by thinking of certain sector funds as being cyclical vs. non-cyclical. Cyclical funds tend to be more sensitive to economic fluctuations while non-cyclical funds are more immune.
Investing in defensive sector funds can make sense when the economy is shaky or approaching a recession. Defensive sectors include consumer staples, utilities and healthcare, which makes sense. When the economy shrinks, people tend to spend less money on non-essentials, such as travel, shopping and entertainment. But they still have to budget for food for their families, go to the doctor and keep up with their electric, water and gas bills.
On the other hand, when the economy begins to strengthen it could make more sense to shift to offensive sectors. If tech stocks are climbing, for example, investing in a tech sector fund could allow you to profit from the ride on the way up. You may also choose to invest in a sector fund that you think may outperform the overall market, despite current trends.
Pros and Cons of Sector Fund Investing
Investing in sector funds can pay off if you’re choosing funds that live up to or exceed your expectations for performance. And because you’re gaining exposure to an entire sector, versus owning individual stocks in that sector, you’re able to insulate your portfolio from risk to a degree. By investing in the sector as a whole, you can capitalize on that sector’s performance, even if some of the companies in that sector aren’t doing as well as others.
On the other hand, investing in sector funds can prove risky because your success often hinges on placing the right bet with your fund choices. You may be expecting a particular sector to do well but then something unexpected, such as a global pandemic, may come along and completely shift the winds in the market. In that scenario, a booming sector could completely tank overnight.
For that reason, sector investing may not be right for every investor. If you prefer more a passive strategy, something like index investing may be the better option. With index investing, you invest in mutual funds that track a particular stock index and attempt to match its performance. The focus is not so much on beating the market as meeting its performance track record.
How to Invest in Sector Funds
If you’re interested in adding sector funds to your portfolio, the first step is getting to know more about individual stock market sectors and how they function. Checking sector performance over time and familiarizing yourself with which sectors are offensive or defensive can help you get a better idea of where sector funds may fit in your portfolio.
From there, you can review your current asset allocation to determine what gaps, if any, may need to be filled. For example, if you don’t have any healthcare exposure in your investments then you may consider adding a healthcare sector fund. Or you may want to add in a consumer staples fund if you’re concerned about the economy heading into a recession in the near future.
Buying individual sector funds is no different than buying other mutual funds. You can purchase them inside your retirement account or through your brokerage account. When comparing sector funds, pay attention to the performance but also take a close look at the fees. The lower the fund’s expense ratio, the better.
Bottom Line
Sector funds can introduce a new type of diversification into your portfolio, but they may not fit every investor’s strategy. Since these funds are so specific in the types of companies and economic areas they target, it’s important to consider how much of your portfolio you’re comfortable committing to them. Keeping an eye on the fees is also important to preserve more of your investment returns.
Tips for Investing
- Consider talking to a financial advisor about the benefits and possible drawbacks of investing in sector funds. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When comparing sector funds, keep the differences between mutual funds and ETFs in mind. While mutual funds close at the end of the day, ETFs trade on an exchange like a stock. But because they tend to have less internal turnover, ETFs can be more cost-efficient from a fee and tax perspective. Also, check out this investment calculator for asset allocation guidance.
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