There is a certain investor type who doesn’t fancy sitting glued to a Bloomberg terminal every day for hours at a time but who still wants to intellectually engage with the market a bit and make some active portfolio decisions. Sector funds are perhaps made with such people in mind.

Sector funds offer targeted exposure to a particular industry sector. First, let’s understand what exactly is meant by “sector” for the purposes of mutual fund analysis. There are varying definitions: a good guide would be the taxonomy employed by market indexes like Dow Jones or S&P. For example, Dow Jones categorizes ten “supersectors”: Oil & Gas, Basic Materials, Industrials, Consumer Goods, Health Care, Consumer Services, Telecommunications, Utilities, Financials, and Technology. These supersectors broadly encompass the economy as a whole. Within each of these supersectors are two additional levels: sectors and subsectors. For example: within the category Financials, Insurance is a distinct sector and Property & Casualty Insurance is a subsector. Likewise under the supersector Consumer Goods one finds the sector Personal Goods and the subsector Footwear (perhaps a popular investment for avid “Sex and the City” types…).

Progressing from the broader market to increasingly narrow definitions of sector, both opportunities and risks present themselves which should be factored into your mutual fund analysis. A key opportunity is the observation that certain sectors tend to outperform or underperform in different stages of a typical business cycle. For example, as the economy heads into a recession businesses and households react, predictably, by making fewer purchases generally and focusing their spending on those things they need the most. Companies will still buy lots of administrative supplies because they have offices to run, but will probably order smaller volumes of raw materials anticipating that sales volumes will decline. Households might decide to skip the weekly Friday night dinner at Applebee’s, but will still need to buy the usual quantities of soap and toothpaste. Sector investors will try to map those types of economic habits to the sectors and companies likely to be the relative beneficiaries. Industries like consumer staple goods, defense contractors and utilities are sometimes referred to as “defensive” sectors for their tendency to do better in recessionary times, while others like consumer discretionary goods, technology and industrial materials are considered “growth” sectors as they often lead the way in the early, fast-paced stages of a recovery cycle.

The flip side to relative outperformance is the added risk that comes from concentrating your bets. By choosing to invest in a specific sector you are adding an element of business risk on top of the systematic market risk that comes from being exposed to the broader equities market. That is to say, your returns are likely to be subject to more extreme short-term volatility than the broader market, and if your bet is mistimed (for example new data points show that the housing market isn’t recovering as expected, or commodities prices are much higher than expected) that can result in much higher than average losses. Risk in this sense is additive: investing in a sector exposes you to the risks of that sector plus overall market risk, while investing in a single stock exposes you to that company’s unique risks plus the sector risks for its applicable industry plus the broader market risk.

Active or quasi-active investors may want to use sector funds less as a core portfolio component and more as an overlay. Say, for example, you have a portfolio that broadly tracks the components of the S&P 500, i.e. your exposure to financials, oil & gas, consumer goods and all the other sectors is roughly in line with the applicable sector weights in the S&P 500. You have been following the economic indicators reported in the Wall Street Journal and see evidence that the economy is headed towards a downturn. As a tactical move ahead of this cycle you can invest in a “peripheral overlay” position – say, a 10-15% position comprised of a consumer goods sector fund and a utilities sector fund as you have observed their historical outperformance in down cycles. By limiting your sector bet to a relatively small percentage of your total portfolio you hedge the downside risk of your assessment being wrong, but you may get some relative performance benefits if your economic assessment was right.

In your mutual fund analysis you should always remember that history seldom repeats itself, and even time-tested sector strategies may not always work as they did in the past. There is no assurance that any given growth or defensive sector will necessarily react to the next business cycle the same way it did for the last ten cycles. Then there is the issue of timing: the darling of one phase in the cycle can be the dog of the next. Financial services stocks performed spectacularly well during the middle years of the 00s decade. If you were slow to unwind your positions when the subprime crisis hit in 2007 and morphed into the meltdown of 2008 all those outperformance gains would have been rapidly erased. Sector investing calls for discipline, agility, and staying abreast of market developments. Make sure you are ready to make that commitment before taking the plunge into sector funds.