Success with Sectors
A tightly focused investing program can help a portfolio thrive, but it's a difficult-and controversial-process.
By Maria Trombly (Financial Planning, Feb. 2003)

To William B. Wixon, CFP and owner of Wixon Financial Services in Plymouth, Minn., the benefits of sector investing are obvious. He got some clients into T. Rowe Price and Putnam energy funds when oil was $13 a barrel and saw it go up $33 a barrel about a year ago. He's also a fan of health care stocks, which have slumped over the last year amid a slow economy. "A doctor doesn't not put a pacemaker in a sick patient just because there's a recession," he says.

Sector investing can be a good way to play such themes without the risk of individual stock selection. According to a recent study from Chicago-based Ibbotson Associates, a balanced portfolio of industry sectors could beat the overall market by an average of 0.55 a year. But the execution of this strategy is complex, and not everyone agrees sectors are the way to go.

Despite the positive results from its study, Ibbocson sounds a note of caution at the start. "Investors should not be chasing the winners," says Peng Chen, vice president of research at Ibbotson. "They should not invest in one or two sectors."

Chen examined a set of standard asset class benchmarks and 10 sectors, using data from October 1989 to June 2002. The study used a basket of the energy, financial, leisure, health, and technology sectors, notes Tom Kolbe, senior vice president and national sales manager at Invesco Funds Group of Denver, which sponsored the research.

Chen recommends building a portfolio around sector funds to fine tune risk and earnings potential. A conservative investor, for example, could have a higher concentration of utilities, energy, and real estate funds, while an aggressive investor would dedicate more of the portfolio to telecom, biotech, and information technology. (Of course, utilities fared poorly in 2002, but the Ibbotson approach has always been to consider long-term performance.)

In addition, Chen says, sectors have low correlations to one another compared with other market benchmarks. While most equity benchmarks move in step with one another, when one sector does poorly, another may do well. As a result, sectors can provide more diversification benefits, according to Chen.

"The performance of a particular stock is determined more by which industry sector you're looking at," rather than a company-specific issue, says Chen. "As the economy becomes more integrated, the industry sector becomes more important in determining stock returns."

So if investors want a diversified portfolio tuned to their risk requirements, Chen says a sector allocation strategy is a better long-term bet than one based on standard asset classes. In fact, Chen claims that if 90 of a portfolio is allocated into a basket of selected sector funds (and thus is not balanced), it could beat the S&P sector indices benchmark by about 1.

Such outperformance could merely be a coincidence, however, according to Brian Bruce, a professor at Baylor University's Hankamer School of Business in Waco, Texas. If there are 10 major industry sectors, says Bruce, some combinations of those 10 are going to do better over a long period of time and some are going to do worse, simply by chance.

"They picked five sectors that didn't correlate with one another and they happened to perform," says Bruce, who is also a monev manager for Boston-based PanAgora Asset Management, which oversees $13 billion in institutional assets. "That's total random chance." In the future, some other set of sector funds would perform better. "That kind of result is not something you should base a conclusion on," he says.

In general, picking sectors randomly will have the same results as the market as a whole, says Sarkis Joseph Khoury, professor of finance at the University of California, Riverside.

Khoury has recently surveyed the evidence behind various approaches to investing, with the results to be published in a book, Wealth Forever, that will be released this spring by Macmillan. His conclusions support Bruce's.

"We can tell you conclusively that buying carefully selected stocks and holding them for a very long time is the best strategy," he says. "You have to be patient and careful, and you can't go with what is fashionable. Right now, sector analysis is fashionable, but I don't believe it's a good strategy."

"We see a real danger to sector investing," says Scan Sebold, CFP and president of Naperville, III.-based Sebold Capital Management. Sebold notes that some fund firms took advantage of investors by advertising their best-performing categories, encouraging investors to switch from the laggards to the leaders.

"Everybody is performance chasing," says Sebold. Four years ago, technology funds exploded. Today, many fund families are pushing their real estate funds, only because they have done well recently. "There's a reason that 90 of investors never make money investing," says Sebold. "And that's it."

The problem is that investors often forget the most common caveat of mutual fund ads-past performance does not guarantee future results.

"When you think you're buying historical returns, it makes perfect sense to chase leaders," says Scott Cooley, editor of Morningstar Mutual Funds.

Some fund companies, such as American Funds and Vanguard, do go out of their way to avoid over-promoting their hottest sector funds, Cooley adds. "They were issuing warnings to people about valuations in the market in the late 1990s," he says. "Lately they've been warning people about the low yields on a lot of bond funds."

Before recommending a particular sector, Sebold does some fundamental economic research. "We believe right now the financial sector is going to outperform, based on the way some government agencies are requiring banks to classify loans," he says. "We see the income numbers are going to be down in the short term, but over the next six months, as these loans become performing loans, there's going to be a big jump in their income." Meanwhile, Sebold expects technology stocks will continue to underperform while real estate and bond funds have peaked.

"What we like to look at when we're evaluating people who give us advice is not necessarily their results but the process they go through," says Sebold. "How they're thinking and whether their methodology makes sense to us." To mitigate the risks of this strategy, Sebold says that he prefers exchange-traded sector funds, both for their low costs and because there's no manager to get in the way.

Wixon watches costs when pursuing a sector investment strategy, but he offers another warning about actively managed sector funds. Some fund companies, he says, use those funds as training grounds for new managers and cycle them in and out rapidly. "Go with a manager of a fund who's been doing it for a minimum of five years," he says.

But following even the best economic advice doesn't necessarily give investors an edge, says Gary Gensler, tormer Treasury undersecretary in the Clinton administration. "For example, right now we're going to go to war, and the military will buy a lot of equipment," says Gensler. "So I should buy the defense sector. But every other American knows we're about to go to war and is investing in defense funds," Even experts with deep industry knowledge can't be counted on do any better than the average, contends Gensler, who recently co-wrote a book titled The Great Mutual Fund Trap. "It's a fool's errand," he says.

Some planners also believe sector investing can often cost more than other investment strategies. "There are some no-load funds that are available for sector investing," says Denny Purser, CFP and president of Greenville, N.C.-based Purser Financial Solutions. "But by and large the internal expense ratios tend to be a little higher because they have to be so actively managed."

Purser also cites the danger that some fund companies put their leastexperienced fund managers on sector funds and move them up quickly, resulting in high turnover.

So how can investment advisers guard against making sector investment mistakes? Purser advises moderation, noting that sector funds should compose no more than 5 to 10 of a portfolio, depending on the risk tolerance of the investor. Nevertheless, if clients are determined to invest all of their money in a particular industry, it can be hard to change their minds, Purser says.

One strategy he uses with overeager clients is to bring out historical charts and show the peaks and valleys associated with particular industries.

"If you look back at the historical returns of various sectors, it should be clear that sectors have great run-ups, but they're typically followed by sharp downturns," Purser says. "Some clients you can't convince-but they are a lot more convinced now than they were two or three years ago." FP

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