Sector funds are in vogue as emerging markets struggle to recover
A mainstay in most US portfolios, sector funds are increasingly making waves in UK and European financial circles. Industries may take their turn in the limelight, but investors who have caught the latest fads, particularly in technology, financial services and pharmaceuticals, have profited handsomely. For fund managers, it means poring over company information in greater detail and selecting their stocks even more carefully to capitalize on the latest fashion craze before it hits the catwalk.
‘Sector funds have definitely become more popular,’ notes Sam Stovall, senior investment officer and sector strategist for Standard & Poor’s in New York. ‘A few years ago, there were only a handful available, mainly from Fidelity, but now there are several hundred. Investors are looking to improve their performance without taking on too much risk. It may be more risky to invest in a sector than a diversified fund but the rewards are greater and it’s less of a gamble than putting your money into just one stock.’
Sector funds have come into vogue over the last year in part because emerging market funds, once the darlings of the stock market, have lost their luster against the faltering Asian backdrop. ‘Previously many investors were sold on the idea of investing in emerging markets as the growth element of their portfolios,’ notes Tim Woolley, head of Henderson Investors’ Global Technology Unit Trust. ‘Now, many have switched their allegiance to sectors that carry the higher risk/reward opportunities.’
According to US-based Lipper Analytical Services, emerging market funds plunged 31.9 percent in the year to June 30, 1998. The Pacific ex-Japan funds showed the largest drop at 53.2 percent, closely followed by the China funds at 50.9 percent. Latin America also suffered a knock-on effect with a 24.2 percent decline.
Top performers
Perhaps it’s no wonder then that investors have become attracted to the higher yielding sector-focused option. After all, growth industries, such as technology, telecommunications and healthcare, have grabbed the top spots as the best performing international equities.
Despite the recent turbulence experienced by many world markets, ‘There are always one or two sectors that are outperforming the market,’ according to Jim Schmidt, whose Timer Digest newsletter based in Greenwich, Connecticut boasts the second best ten-year sector portfolio track record – up 18.8 percent last year. ‘Our objective is to find sectors that are moving faster than the S&P 500 index (up roughly 16 percent for the year to June 30, 1998) and if you can do that then you will outperform the benchmark by a wide margin.’ Currently, his portfolio is concentrated in four of Fidelity’s sector funds – brokerage, leisure, telecommunications and regional banks.
Compared to the MSCI index, which rose by about 16.3 percent over the past year, and the US stock market, which clocked a 17 percent gain, telecom funds have been the star performers, up 38.2 percent in the year to June 30, 1998, according to Lipper. Financial service funds were close behind with a 35.1 percent gain while science and technology rose 22.7 percent, and health/biotechnology roughly 18 percent. However, investors lost on gold funds, down about 35 percent, and natural resources, off roughly 11 percent due to weak commodity prices and poor market conditions.
‘Investors are looking for long-term, interesting growth prospects which is why some sectors are in fashion one year and out the next,’ explains Johan Held, fund manager with Stockholm-based SE Banken, which has a five year-old stable of global sector funds including healthcare, pharmaceutical, technology, environmental and natural resources. ‘It is important to remember, though, that they are not the right investment vehicles for everyone. Sector funds are better geared for the more proactive investor who is interested in market trends, takes a particular view on a certain sector and is willing to shoulder the higher risk of all the assets being concentrated in one industry.’
And although sector funds are slowly taking off in Europe, with Fidelity, Framlington, Henderson Investors, Jupiter and SE Banken leading the march, Held does not believe they will ever become a ‘widespread phenomenon, mainly because too many industries are cyclical in nature and are simply not suited to become sector funds.’
Steven Lipper, vice president of Lipper Analytical Services, agrees: ‘Sector funds get a disproportionate amount of attention relative to their performance and importance.’ Only $111 bn or slightly less than 5 percent of US-based mutual funds are invested in sector funds out of the massive $2.4 trillion of total assets. As he puts it, ‘Interest has waxed and waned over the years. Most investors use mutual funds for financial planning whereas the more aggressive investor will probably look at sector funds as an alternative to individual stock selection. Also, sector investors are only in these funds for short periods – typically about six to twelve months – compared to the five to ten-year holding patterns for the traditional broadly-based diversified funds.’
Management concerns
As for the actual intricacies of managing, the styles naturally vary according to the fund management house and their particular culture and ethos. ‘I do not see much of a difference between managing sector funds or broadly-based diversified funds,’ says Held. ‘Perhaps there is a slightly heavier burden on the fund manager to provide more information and keep investors abreast of the latest developments if it is a fast developing or changing industry. However, the criteria we use, and the quality and the level of detail of information we expect from a company, are the same for all our funds.’
SE Banken, for example, adopts a bottom-up approach for its six sector funds, the largest two being healthcare with $650 mn of funds under management, and technology with $440 mn. ‘We do not look just at one component, but several, such as product line, profitability and valuation,’ says Held, ‘Management is also a key factor, especially in technology because developments occur at such a rapid pace.’
Woolley, on the other hand, who runs Henderson Investors’ £130 mn technology unit trust, believes that technology is a field where the investor relations people should not only have an in-depth ‘understanding of the business, but be up to speed with the latest developments and trends.’ He also views the technology world from a bottom-up perspective and places great emphasis on the quality of management. ‘If the managers cannot market the products, it does not matter how great the technology is.’
Jupiter, whose sector menu includes a £69.4 mn Ecology Fund and a £36.75 mn Financial Opportunities Fund, puts companies through its own valuation paces. Jupiter fund managers are stock-pickers and look for undervalued growth companies in the US, UK and Europe. Top of their priority list are a strong cash flow and a committed management team with significant stakes.
Simon Baker, fund manager for Jupiter Ecology, says he seeks ‘companies that provide profitable solutions to environmental problems.’ Companies are also ethically screened which means that those involved in animal testing, tobacco, alcohol, nuclear power, production of pornographic material or gambling will not be considered.
Looking down
Other fund management houses – such as Framlington – favor a top-down approach starting with the larger macroeconomic picture and then focusing on the trends that affect the particular industries, according to Richard Pierson, manager of UK equities and also head of the company’s successful £85 mn Financial Fund. ‘We take a broad view of the financial services sector,’ he says. ‘This could mean investing in a major financial services player such as a bank or insurance company, or a firm that services the sector such as credit card processing or software packages.’
Finally, there are fund managers that are just interested in value for money. ‘We take the emotions out of investment,’ says Craig Callahan, president of Meridian Investment Management in the US, one of the largest sector players with its Icon group of funds. ‘Our approach is purely quantitative and based on Benjamin Graham’s techniques to determine the fair value of securities. We look at 1,700 US stocks every week and factor in their historic earnings averages, projected growth rates, beta and the yield on AAA-rated bonds. We then rank them by which industries are offering the best value.’