While the first few decades of the modern mutual fund industry was largely occupied with building up a large variety of broad market and style funds (along with index funds), recent years have seen the expanse of much more specialized funds. One of the innovative offerings by mutual funds companies includes sector funds—mutual funds that invest only the companies that operate in a given market sector, such as Energy, Financials, Telecom, Information Technology, Utilities, etc.
Many of the largest mutual fund companies offer sector funds: Fidelity manages more than $13.5 billion across ten different sector funds (and also manages 34 industry-specific funds, which focus on specific industries within the ten broad sectors), while Vanguard manages a $22 billion Healthcare sector fund and a $14.5 billion Energy sector fund. Considering the availability of these funds should you add them to your portfolio?
The biggest advantage to investing in a sector fund is the ability to target a specific segment of the economy, either to increase or decrease exposure. For example, if you have a broadly diversified portfolio but feel that the financial sector will outperform over the next few years as the bad banks were weeded out, you can easily increase your exposure to financials without having to alter your original portfolio.
You may also be able to build a portfolio entirely of different sector funds, and then instead of just increasing your exposure to one sector that you favor, you can also sell a sector that you think will underperform. For example, you would have a hard time avoiding the energy sector in a broad market portfolio, but with sector funds you can invest in all the other sectors excluding the energy sector.
Finally, you can manage the risk of your portfolio easily by adding and removing the sectors that are more risky or volatile. For example, utilities have very steady cash flows and typically have steadier prices than the market; therefore, during a bear market you may want to decrease your risk by increasing exposure to utilities.
The biggest disadvantage to sector investing is that the portfolio will not be very diversified. Since you are investing in only one sector at a time, the sector may hold a relatively small amount of securities, and you are depending on that sector to perform well without being able to balance out potential losses with gains from other sectors. However, building your own portfolio of diversified sectors can help mitigate this problem.
The increasing specialization and advancement of the mutual fund industry may present the average investor with opportunity. By using sector funds to your advantage, you will be able to manage your portfolio to your own liking without having to rely on a broad market fund or index.