Sector funds are a type of money market fund or ETF. They are a collective investment scheme that focuses their investment efforts on a specific piece of the market.
You can find a sector fund for almost every fraction of every industry, including health care, real estate, precious metals, communications, financials, natural resources, technology and utilities. Plus, you can find even more specific sector funds within each of those categories.
How Sector Funds Work
A sector fund pools money from investors and uses it to buy stocks or other securities from companies within a specific sector of the economy — like technology, health care, energy or financials.
You can invest in a sector fund through a brokerage firm. The fund manager will choose a particular sector or industry and select companies to invest in. The investment can be a mutual fund that is actively managed or an ETF that requires a lower cost and is more of a passive investment. Some sector funds offer dividends.
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Types of Sector Funds
There are different types of sector funds. Find out the types and which one works best for your portfolio and the current economic cycle:
Technology Sector Funds
These sector funds focus on tech-driven companies like software, semiconductors, cloud computing and AI. These sector funds have the opportunity for growth, but investors have to be comfortable with volatility and uncertainty.
Health Care Sector Funds
Health care sector funds are likely companies that are familiar to you. This sector fund focuses on pharmaceuticals, biotechnology firms, medical device manufacturers and health care providers. These funds are considered more stable, especially during economic downturns.
Energy Sector Funds
Oil, natural gas and renewable energy are part of energy sector funds. These specific funds are sensitive to global demands and commodity prices. They tend to thrive in times of economic boom.
Sector Funds vs. Broad Market Funds
There is an inherent risk in investing in sector funds because they focus on one industry. This is because an entire sector can experience a downturn at once. In contrast, if your investment strategy focuses on broad market funds, you are spreading the risk across multiple sectors.
Here is a comparison chart highlighting the differences between the two:
|
Feature |
Sector Fund |
Broad Market Fund |
|---|---|---|
|
Diversification |
Low; One industry focus |
High; Spread across many industries |
|
Risk |
Higher; Less diversified investments |
Lower; More diversified investments |
|
Rate of Return |
Higher if sector outperforms |
Stable and consistent |
|
Best for |
Market trends |
Long-term growth; Core portfolio growth |
|
Sensitivity to economy |
High – depends on sector cycle |
Moderate – a reflection of the overall economy |
|
Examples |
Energy, health care funds, utilities |
S&P 500, Total Market Fund |
|
Use Cases |
Investors want to capitalize on specific industry trends; used to supplement a portfolio |
Great for long-term, passive investors; core holding in most portfolios |
How to Invest in Sector Funds
Investing in sector funds works similarly to any other investment. Here is a step-by-step guide:
Step 1. Open a Brokerage Account
Use a trusted brokerage firm like Fidelity, Vanguard or Charles Schwab that routinely offers access to mutual funds and ETFs. All three brokerage funds cater to beginner and advanced investors.
Step 2. Research Sector Performance
Do your research. Find out current economic conditions and market trends. Use those markers to identify sectors with strong growth potential. Look for industries benefiting from innovation, consumer demand or favorable regulation.
Step 3. Select a Sector Fund
Choosing a sector fund to invest in is where you can blend your research with market trends. Decide what sector you’d like to invest in and focus on historical returns, expense ratios and fund objectives before taking the leap.
Strategies for Investing in Sector Funds
Unfamiliar with the strategies for investing in sector funds? Consider these approaches:
Tactical Allocation
This is a balanced approach that includes sector funds, but your portfolio is diversified across the broader market. There is an expectation that your sector fund will outperform other investments.
Rotational Investing
Use your sector funds to create rotational investing. You invest in certain sector funds based on market trends and economic cycles.
Dollar-Cost Averaging
Invest a fixed amount regularly into sector funds to reduce the risk of poor market timing and smooth out price volatility over time.
How to Choose the Right Sector Fund
Wondering which sector fund is right for you? You should consider the following factors and also talk to a financial planner to determine if a sector fund is the right investment for you.
Aligning With Your Investment Goals
What are your investment goals? If you’re striving for capital preservation, sector funds aren’t ideal. However, if you’re looking for growth, target sectors like clean energy, tech or biotech. If you’re looking for income, look at sector funds that pay dividends like utilities and REITs.
If you’re focused on short-term gains that happen in less than three years, sector funds may not be ideal for your time frame. For a three- to seven-year range payoff, sector funds can be a part of your strategy if you believe in the sector fund’s momentum. For long-term payoff (greater than seven years), you need to be willing to ride out the market cycles to capitalize on sector funds’ full potential.
Evaluating Fund Performance
What is the historical data on the sector fund that seems like an appealing investment? Make it a priority to see how the sector fund has done in the first, third and fifth year.
You will also want to know the expense ratio — how much of an annual fee the fund charges. The lower the annual fund fee, the more incentive you have to invest.
Consider the top holdings of the sector fund. Are the companies strong and reputable leaders in the sector?
Considering Economic Cycles
Timing your sector fund investment based on economic cycles is a possible approach to managing your overall portfolio. When the economy is in the early recovery phase, people are spending more money, borrowing increases and businesses ramp up their production. This is a good time to invest in the financial and industrial sectors.
When the economy is in the mid-expansion phase, businesses are investing in innovation and productivity increases. In this economic cycle, it is likely ideal to invest in technology, communication services and technology sectors.
In late expansion cycles of the economy, growth slows, inflation rises and interest rates may increase. During this time, it makes the most sense to invest in the energy, materials and utilities sectors.
When the economy is going through a recession, there is an economic slowdown, falling profits and higher unemployment. You want to invest in sectors that will thrive despite the economy. These sectors generally are health care, consumer staples and utilities.
FAQ About Sector Funds
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What is a sector fund, and how does it differ from a mutual fund?
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A sector fund is a type of mutual fund or ETF that invests in a specific industry like technology or health care. A mutual fund is an investment in several industries.
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Are sector funds good for beginner investors?
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It’s typically not the best investment for beginners since it discourages diversification. Sector funds are usually riskier.
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How do I know which sector fund is right for my portfolio?
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You can evaluate whether the sector fund complements your existing portfolio. Also, you should ask yourself whether you believe in the particular industry that you’re choosing to invest in. Check the fund’s history, volatility and expense ratio.
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This article originally appeared on GOBankingRates.com: What Are Sector Funds? A Beginner’s Guide to Targeted Investing