A new range of fund options (3)
The mutual fund world has changed dramatically in recent years, with whole new categories of funds appearing. In this third of a series, we look at sector funds, which have become very popular in the past few years.
A decade ago, there were very few of these in Canada. Now there are several hundred on offer. A sector fund concentrates on one specific area of the economy and most or all of the portfolio is invested in companies that are directly in that business or are closely related to it. Because these funds are so tightly focused, they tend to be much more risky in nature. When the sector does well, the gains can be spectacular. But when the sector is out of favour, the losses can be heavy. As a result, many investors treat sector funds like cyclical stocks. They buy units when the prospects for the particular sector look bright and sell before the next downturn. The trick, of course, is in the timing.
Some of the most popular types of sector funds are:
Natural resource funds. The emphasis is on the resource sector, which includes mining, oil and gas, forest products and the like. Some funds narrow the focus even more, by honing in on a single indtry, such as energy. Precious metals funds have been given a separate category of their own, but actually they belong with this broad group.
Science and technology funds. The tech boom of the late ‘90s gave birth to dozens of science and technology (S&T) funds, many of which scored huge gains during the period when Nasdaq was running wild. There are a number of sub-sets within this broad grouping, including health sciences funds and telecommunications funds.
Financial services funds. As the demand for sector funds grew, the industry scrambled to find other concepts that would appeal to investors. Financial companies, such as banks, insurance firms, brokerage houses and the like, fit the bill nicely and new funds that specialize in them have appeared in recent years. By their nature, the stocks held by these funds will tend to be interest-sensitive, which means that the general direction of rates will have an impact on their prices. So the best time to buy into a financial services fund is when it appears that interest rates are about to decline.
Real estate funds. There are two basic types of real estate funds. One invests in the shares of real estate companies, and those in related industries. This makes them similar to other sector funds in their approach and the primary objective of the manager is to produce capital gains. The second type is quite different, however. These actually own land and buildings, usually in the form of rental properties. In this case, the main goal is to produce tax-advantaged income. Depreciation on the properties owned by the fund can be used to shelter part of the rental revenue from taxes. As a result, when distributions are made to unitholders, a portion of the income is received on a tax-deferred basis. This type of real estate fund is not recommended if above-average capital appreciation is your goal, but is useful for retired people who want to reduce the tax bite on their investment income.
Index equity funds. These funds track the performance of a specific stock index. In Canada, the TSE 300 is the one most commonly used. The majority of U.S. index funds emulate the S&P 500 Index, although you can find funds that track Nasdaq and the Dow. There are also a number of international index funds available, which may be based on the Morgan Stanley Capital International Europe, Australia and Far East (EAFE) Index, or a combination of individual country indexes. Index funds do not have their own separate category in the current Canadian classification system.
Adapted from the forthcoming book Six Steps to $1 Million, by Gordon Pape, to be published by Prentice Hall Canada in spring 2001. Details on a special pre-publication offer at 25% off!