Be wary of sector funds

Sector funds have proliferated at an amazing rate in Canada over the past decade. There was a time not so long ago when the only industry-specific funds were those specializing in precious metals and natural resources.

Now you can find a fund for almost any sector that interests you.

Many Canadians hold one or more sector funds in their portfolios. In most cases, they shouldn’t.

Risky, lower returns

• In the first place, sector funds are inherently more risky than those with a diversified portfolio.

The reason is simple. The fortunes of these funds will rise and fall with the economic health of the sector in which they invest.

• Secondly, sector funds tend to have sub-par returns.

Most of Canada’s sector funds have not been around long enough to make meaningful long-term comparisons with diversified funds. But there are a few exceptions and they are not encouraging.

Some examples
The average annual return for natural resource funds over five years to November 30th is a decline of 7.1 per cent, with only four funds in the black.

The 10-year pictu is better, with a 5.8 per cent average annual gain.

For precious metals funds, there is an average annual loss of 14 per cent over five years. Over a decade, the average decline is 4.7 per cent.

By way of comparison, the average diversified Canadian equity fund shows a five-year annual return of 5.6 per cent and a 10-year average annual gain of 9.6 percent per annum.

Next page: Science, technology funds

Science, technology funds
In the science and technology category, there are about a dozen funds with a five-year record-none at 10-so we have some idea of what to expect over a longer period.

The average annual return for these funds over five years is 9.9 per cent (again to November 30th).

The average diversified U.S. equity fund, which is a valid comparison for the science and technology industry, has an average annual five-year gain of 8.3 per cent.

On the surface, that may look like an argument in favour of technology funds, but ask yourself this question: How many people are likely to have held their units over a full five-year period in the face of the spectacular ups and downs the category has experienced?

My guess is only two types of investors: Those with ultra-strong stomachs and those who have gone to sleep.

Too volatile to call
In fact, the science and technology category is so volatile that the balance shifts from month to month. At the end of October, the diversified U.S. category had the five-year edge. Thanks to a strong resurgence in tech stocks, S&T funds regained the lead at the end of November. Who’s to know what will happen next?

Investing in sector funds is much more risky than buying a diversified portfolio and the additional profit potential is not enough to offset the high volatility, at least for the average investor.

I recommend that sector funds be used only by those who are prepared to trade them like stocks, buying at the lows and selling after the fund has produced a good profit.

Everyone else should stay with funds that offer a well-diversified portfolio. Leave the sector decisions to the managers.

Adapted from the December 2002 edition of Mutual Funds Update.