Sector Fund: What it Means, How it Works

What Is a Sector Fund?

A sector fund is an investment fund that invests solely in businesses that operate in a particular industry or sector of the economy. Sector funds are commonly structured as mutual funds or exchange traded funds (ETFs).

Understanding a Sector Fund

Sector funds focus on one area of the market, known as a sector, by investing in companies that operate in the fund's chosen sector. A sector consists of one line of business that provides the same or similar product. Some common sectors include the financial sector or the technology sector. JPMorgan is in the financial sector while Apple is in the technology sector. Sector funds allow investors to take targeted bets on the appreciation potential of a particular industry category.

Certain sectors may offer high growth potential due to economically driven investing catalysts; however, investing in a specific sector has a high risk potential and more volatility as it is a concentrated investment with no economic diversification.

Sector funds do offer the advantage of some diversification through multiple holdings in a portfolio; however, overall sector funds will have idiosyncratic risks that affect the entire portfolio due to their targeted sector exposure. If one sector performs poorly, the fund focused on that sector will do so as well, without any offset from investments in a sector that is performing well.

A sector fund will have portfolio constraints requiring the portfolio manager to choose investment securities for the fund that fall within the fund’s targeted objective. The investment manager will not be allowed to invest in any other sectors per the mandate of the firm. If the strategy of the fund is to change, the investment manager has to notify the investors, as they may be investing in the fund/sector as part of a broader portfolio strategy.

Some sectors and sector fund investing categories may require greater due diligence than others, as certain sectors are typically associated with market cycles. Consumer cyclical stocks, for example, include companies involved in automotive, housing, entertainment, and retail activities. These companies and market sub-sectors do well when an economy is growing but poorly when an economy is not. Consumer staples stocks, including companies involved in home utilities, food, beverage, and household items are known to be more stable through all types of market cycles.

Sector Funds and Beta

Generally, one way to follow the risks and volatility of a sector is by following its beta. From 2017 to 2020, the Standard and Poor's (S&P) technology sector index reported one of the highest sector betas at 1.03, and the utilities sector one of the lowest betas at 0.17. The technology sector reported a return of 50% in 2019, beating the S&P 500 Index’s return of 31.5%. The return of the utilities sector was 26.4%, just below the Index’s return, as expected by its lower beta. 

Sector Fund Investing

Investing in specific sector funds is quite a simple process as there are many funds that actively or passively invest in different sectors of the market. An active sector fund would actively decide what shares should be in the portfolio based on their expert analysis. They may include or remove companies from their portfolio often.

Passive sector funds typically track an index. The S&P has numerous sector indexes for tracking, which are:

• S&P 500 Consumer Discretionary Index
• S&P 500 Consumers Staples Index
• S&P 500 Energy Index
• S&P 500 Financials Index
• S&P 500 Healthcare Index
• S&P 500 Industrials Index
• S&P 500 Information Technology Index
• S&P 500 Materials Index
• S&P 500 Real Estate Index
• S&P 500 Communication Services Index
• S&P 500 Utilities Index

It is usually advised to invest small portions of your investment allocation into sector funds due to their volatility and to incorporate sector fund investing as a larger part of your portfolio to add diversity. For example, an investor could follow a core-satellite investment strategy, whereby an investor chooses a core holding, whether a blue chip company or a diversified index fund, that is allocated a large portion of the investment capital, and then chooses satellite investments, such as a sector fund, which compromise a small allocation of investment capital.