What is a “Sector Fund”?
Sector funds are collective investment schemes that solely invest in companies that operate in a particular segment of the economy. They can be active or passive and are usually structured as an open-ended fund or exchange traded fund (ETF). Most investors find these vehicles useful for getting exposure to a specific trend in the economy or a sector in which they have a strong conviction. From a portfolio construction perspective, sector funds could be best utilized as a satellite holding to complement a core portfolio due to the concentrated single segment exposure and higher level of risk respectively.
Key Learning Points
● A Sector Fund is a collective investment that bets only on businesses from a particular industry or sector of the economy
● Sector Funds can be active (mostly mutual funds), in which case an investment professional aims to deliver excess returns above a predetermined benchmark, or passive (primarily ETFs) where an automated system tracks closely a specific market index
● These funds rely solely on a specific sector of the economy to perform well and are therefore expected to be more volatile than the broader market due to the lack of diversification
● Sector Funds are usually used as a satellite holding in a well-diversified portfolio
● Most often, a Sector Fund’s purpose is to generate capital growth or additional income
Advantages and Disadvantages of Sector Fund Investing
The biggest advantage of sector funds is the potential for more aggressive growth relative to the market should the designated sector do well. This can really depend on how the fund is structured and whether it covers a single country or a specific region’s sector or offers global exposure. By spreading the risk across a bucket of specific industry companies it can provide a smoother return than betting on a single business. For example, while still a high risk, a fund that invests in global energy (i.e. energy companies around the world) is expected to provide a relatively more smooth and diversified experience compared to investing in a single stock such as BP or Royal Dutch Shell. Sector funds, and especially the passive ones, are also a good option for those who want to take short-term tactical positions or even bet against that sector through the use of inverse ETFs.
However, higher volatility is the biggest disadvantage of sector funds. Due to the lack of industry and sector diversification, these strategies tend to be more volatile than the broader market. Even gaining exposure to more defensive areas such as Healthcare has its own risks should the sector fall out of favor (in this instance, typically when the overall market outperforms).
Sector Funds Vs. Thematic Investing
Along with the large expansion of sector funds over the recent years, thematic investing is another rapidly growing trend. However, the two concepts have strong differences – while sector funds offer sector specific exposure (such as financials or infrastructure), thematic investing focuses on a specific theme that may offer exposure across multiple sectors. For example, a thematic ESG strategy may apply negative screening and exclude businesses that operate in the gambling or tobacco sector, but may include companies from sectors such as pharmaceuticals, technology, or renewable energy.