Should investors take a new look at sector funds?
Last week, I extolled the virtues of obtaining investment portfolio diversification by investing in broad-based market index mutual and exchanged-traded funds. As you may remember, this strategy is relatively safe, inexpensive and easy to accomplish.This week’s recommendation for an investment strategy is going to send you in the opposite direction. Sector mutual funds, as well as their alternatives in the exchanged-traded field, focus their holdings on specific industries or narrow segments of the market. The idea is to outperform the general market by concentrating a portfolio’s assets in a single favorable investment category.These days, the best-known and most popular sector funds include real estate, energy, natural resources, precious metals, and gold. Other sector funds that have been around for a number of years include financial services, health care and selected technologies. Investopedia.com’s Web site dictionary definition of a sector fund provides an excellent perspective on the pros and cons of this type of investing opportunity:”Because the holdings of this type of fund are in the same industry, there is an inherent lack of diversification by sector associated with these funds. These funds tend to increase substantially in price when there is an increased demand for the product or service offering provided by the businesses in which the funds invest. On the other hand, if there is a downturn in the specific sector in which a sector fund invests, the fund will face heavy losses due to the lack of diversification in its holdings.”In recent history, the popular sector-fund categories I mentioned above have been on a tear. I’ve picked five sector funds to highlight this performance. For comparison purposes, let’s use the record of the S&P 500 Index on a three-year annualized (2003-2005) and the first quarter of 2006. For these periods, the S&P was up 17.2 percent and 4.2 percent, respectively. Here’s the take on the selected sector funds for the same periods:Vanguard Energy (VGENX) is a pure oil and gas play: up 42.9 percent and 11.4 percent. American Century Global Gold (BGEIX) is a gold fund: up 33.6 percent and 18.7 percent. Vanguard Precious Metals and Mining (VGPMX) focuses on a range of mining commodities: up 48.6 percent and 21.6 percent. T. Rowe Price New Era (PRNEX) has a broader natural resource base than just energy: up 36.4 percent and 9.7 percent. And, lastly, Fidelity Real Estate Investment (FRESX) favors blue-chip REITs: up 32.15 percent and 13.6 percent.It is not unusual for one or two market sectors to outperform the overall market. From the above, you might get the impression that that is no longer the case. However, a close look at these funds indicates that, with the exception of real estate, these sector funds are focusing on commodities in one form or another.Conventional wisdom tells us that commodity prices are volatile, which makes the stock prices of commodity-based companies equally volatile and subject to overvaluations, i.e., high price-earnings (P/E) ratios. However, I’m wondering if the economic recovery of the world’s second-largest economy, Japan, and the ever-increasing appetite for raw materials of big-time consumers like India and China are going to change the traditional commodity pricing paradigm for the foreseeable future. If so, with the exception of gold’s (BGEIX) lofty P/E ratio of 44.5, the low average portfolio valuations (P/E ratios between 9.2 and 16.2) of the other commodity sector funds look attractive. Even the real estate Fidelity REIT is at a very reasonable 17.6 valuation.Normally, a big run-up in these sector funds would indicate caution; the big money has been made. However, the commodity sector might warrant a different look. I wouldn’t suggest a big bite with new money, but a little nibble might be worth the risk.The Investing Wisely column is written by Richard Loth, Managing Principal of Mentor Investing, an independent registered investment adviser. Loth can be reached by emailing to email@example.com or calling (970) 328-5591.Vail, Colorado