"At the recent RealAdviser Forum, one of the speakers highlighted the usefulness of 'sector funds' before mourning how few there now are. Is that not a case of survival of the fittest or should I be taking a closer look? If so, what still existing sector funds do your experts like the look of going forward?"
tim cockerill,rowan & co
You have hit the nail on the head - funds are products and are no different from products in any other business. If a product is not popular and presumably not profitable it will be pulled or, in the case of funds, merged with another.
Sector funds can present numerous difficulties. You have to have strong views on what sectors are going to perform well but, even when a sector performs well, not all of the stocks within it are necessarily going to perform. Then you have the issue that some sectors are very diverse and the drivers behind the performance of the stocks will be varied - for example support services.
Conversely, some sectors are too small to allow for proper diversification - for example, tobacco, a sector that has been a very good investment. Then there is the issue that, within an index, such as the FTSE All-Share, sectors are not evenly matched - there the banking sector is very large whereas the industrial metals sector is small. Consequently, constructing a portfolio is made more difficult.
There is also the issue of sector rotation - where one sector is in favour with the market, followed by another sector and then another. Timing in this type of market is difficult. Even trying to call whether a market is going to be a 'value' or 'growth' market is difficult - as is calling whether large caps are going to outperform mid and small caps.
After all, large caps have been 'good' value for some time but they have yet to outperform. Sector funds also encourage trading because of the need to have a view, which presupposes a period when that view changes and the fund will be sold.
Asset managers do not want heavily traded funds because they want to build assets under management - another reason sector funds are rare. Exchange-traded funds or 'ETFs' are a more suitable vehicle for sector investing and, in the US, there are ETFs in a broad range of sectors. In the UK, however, they are index-focused, except for a range of commodity ETFs launched recently.
The main sector funds that are still thriving are those that are quite specialised but broad, such as technology, biotechnology and healthcare, financials, property and resources. But you have to beware sectors that spawn a rash of new launches as this has a nasty habit of happening at periods of inflated values.
When constructing a portfolio, balance is important and specialist funds should be treated with care. They may offer asset diversification - as property does, providing it is via bricks and mortar funds - but they can increase risk within a portfolio considerably.
It is fair to say fund management companies have a pretty shameful track record of rushing specific sector funds to the marketplace at the top of the market then closing them at the bottom. There was no better example than the flood of new technology funds in the first quarter of 2000, many of which had been closed by late 2002 at a substantial loss to investors.
With this in mind, one should be suspicious of any sector that sees a sudden spate of launches and the current favourite is the commodity arena, which has seen the recent launch of 26 exchange-traded commodities or 'ETCs', making the concept more readily available to private investors - usually the last to the party.
However, at certain times in the cycle, sector funds do provide a genuine diversification benefit. In July, we took the view the global economy would slow in 2007 and we should sell our cyclical sectors - particularly commodity-related holdings - and look for sectors that were under-owned, undervalued and less sensitive to economic slowdown.
The first sector we invested in was biotechnology and healthcare, through Axa Framlington Health and Pictet Biotechnology. The mean absolute and relative large-cap biotech valuation was at its lowest point ever. The sector is also under-owned - investors have been focused on cyclical areas of the market such as commodity and energy sectors rather than growth sectors like biotech. From an economic viewpoint, a slowdown should benefit non-cyclical growth sectors as investors change focus to high-quality growth stocks.
The same thought processes have also encouraged us to dip our toes into water as a sector - not just utility companies but water treatment, water technology and environmental services and the fund bought here was Pictet Water. Since the purchase, AWG and Thames Water have fallen to bids, the Chinese have announced £66bn of spending on water projects over the next five years and water stories are constantly in the news.
We also expect technology stocks to outperform in 2007 and have bought Polar Capital Global Technology and First Asia State Innovation & Technology. Valuations on tech stocks globally are low on a relative basis - since fingers were burnt in 2000 - and, with corporate balance sheets in good health after record US profits, tech spend should increase to improve efficiency in a slowing economy.
jason britton,t bailey
Sector funds are still early in their development cycle. The globalisation of the late-1980s and the 1990s has finally levelled the playing field across many industries around the world and allowed historically domestic-focused companies to expand internationally to the position today where 58% of the FTSE 100's earnings arise from overseas sources.
This trend has also allowed the rise of sector funds that can specialise in an industry or collection of industries without concern as to the location of those companies' stockmarket listings. Because of the comparatively recent development of the above, the number of sector funds is still quite limited, restricting choice, which also theoretically impairs the quality available.
We expect many more sector funds to spring up over the course of the next few years as portfolio managers migrate from a traditional geographic asset allocation to a sector-based approach. Be aware though that focusing investments around one particular industry can be risky as investors in technology funds in early 2000 will painfully recall. Placing so many eggs in one basket does not encompass the benefits of diversification. Another drawback is the need to buy and sell more frequently than one might with certain geographic funds.
A geographic-led investor is always likely to want an exposure to the UK and the US, even if at times they might want to alter the ratio between them. However, would one always want to have an exposure to biotechnology or telecoms - industries that wax and wane and are much more cyclical? Investors using sector funds must be prepared to monitor their holdings more closely and for a greater frequency of trading and the costs involved therein.
A few sector funds do catch our eye though, New Star Global Financials being one. The £167m fund has been managed by Guy de Blonay since its launch in December 2001 and, as its name suggests, it focuses on the financial sector worldwide. The fund is very concentrated with the top-10 holdings accounting for about 40% of the portfolio, which implies the manager is a man of conviction who knows exactly how much of a certain stock he wants to hold and who is prepared to give his most favoured ideas all the support they need.
Another is JPM Natural Resources. Although this fund has seen stellar returns over the last five years, many feel the commodities story still has further to go. Alternatively, for those anticipating the oil price will again move northwards to new heights, Investec Global Energy may be of interest.
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