How To Invest in Sector Funds

You've heard that investing in certain sectors of the economy can be a smart thing to do. But how does one go about choosing the best sector funds for their portfolio? Why invest in sectors, and when is the best time to invest in them? What are the benefits and strategies of investing in sector mutual funds?

What Are Sector Funds?

A sector fund is a mutual fund or an exchange-traded fund (ETF) that invests most or all of its assets in one particular industrial sector. There are many ETFs and mutual funds for every sector, and each respective sector fund may have a slightly different set of holdings, even if they invest in the same sector.

Here's a list of sectors, along with examples of stock holdings you may find in them.

Technology and Financial

Technology sector funds invest in stocks of companies that produce technology products or offer technology-based services. Examples would include a software manufacturer like Microsoft (MSFT), an online retailer like Amazon (AMZN), a social media site like Meta (FB), formerly Facebook, or a tech firm like Google parent company Alphabet (GOOG, GOOGL), which produces multiple products and services within the technology industry.

Financial sector funds focused on finance will hold stocks of companies like Bank of America (BAC), Charles Schwab (SCHW), and Wells Fargo (WFC). Financial stocks and financial sector funds can include more than just banks and brokerage firms—financials also include insurance companies, mutual fund companies, and financial planning firms.

Consumer Discretionary and Staples

Consumer cyclical stocks (also called consumer discretionary stocks) include companies like Disney (DIS), McDonald's (MCD), and Starbucks (SBUX). These are companies that sell things that people don't need for daily living.

Therefore, consumer cyclical stocks tend to do better when the economy is strong and consumers are spending. That's why they're sometimes called consumer discretionary or leisure stocks.

Consumer staples are nearly the complete opposite of consumer cyclical stocks; companies in the consumer staples sector typically provide products and services needed for everyday life. Examples of consumer staples companies include Colgate-Palmolive, Johnson & Johnson, Procter & Gamble (PG), and Philip Morris. These companies manufacture items such as soap, toothpaste, deodorant, and tobacco products.

Utilities and Energy

Companies in the utility sector provide products and services related to gas, electricity, and phones. Stocks in the utility sector include Duke Energy (DUK) and Southern Company (SO). Like consumer staples, utilities will include products or services that consumers still use when times get tough.

Therefore, sector funds that invest in utilities can perform better than growth-type sectors, such as technology, when a recession hits. For this reason, utilities are one of the primary defensive sectors.

The energy sector consists of all the industries involved in producing and distributing energy, including oil companies, electric companies, the coal industry, and green energy companies harnessing wind and solar power.

You can also buy energy sector funds that are further specified by their emphasis on green energy production.

Health Care and Real Estate

Also known as health or specialty-health, this sector focuses on the health care industry. It includes hospital conglomerates, institutional services, insurance companies, drug manufacturers, biomedical companies, or medical instrument makers.

Examples include Pfizer (PFE), UnitedHealth Group (UNH), and HCA Healthcare, Inc. (HCA). In addition, health sector funds also often hold biotechnology stocks like Gilead Sciences (GILD) or Biogen (BIIB).

The real estate sector funds typically concentrate their holdings in real estate investment trusts, or REITs, which are entities that represent a collection of investors that pool their money together to purchase income-producing properties, such as office buildings and hotels.

REITs are legally required to pay out at least 90% of their income to shareholders, making real estate sector funds attractive if you're looking for income-producing investments. Some top holdings in a real estate sector fund might include Simon Property Group (SPG) and Public Storage (PSA).

Resources and Metals

Sector funds focused on natural resources will typically invest in commodity-based industries such as energy, chemicals, minerals, and forest products. Therefore, shareholders of these sector funds will get exposure to energy stocks like XOM and CVX and stocks like Newmont Mining Corp (NEM).

Precious metal mutual funds would also be better classified as commodities funds because precious metals aren't considered an industrial sector. Still, precious metals deserve mention with sector funds because of its nature as an investment that concentrates its holdings into a specialized portion of capital markets.

How To Invest in Sector Funds

One wise portfolio structure for implementing a sector funds strategy is the core-and-satellite portfolio structure—you begin with a core holding representing the largest portion of your portfolio and then add satellite funds, which make up smaller percentages of your portfolio. For example, one good core holding is an S&P 500 Index fund, which might receive roughly 30% or 40% allocation.

The satellite holdings, which each take up a much smaller percentage of your portfolio allocation, can be small-cap funds, international stock funds, or sector funds. Sector funds work well as diversification tools and as a possible means of increasing portfolio returns.

When you add sector funds to the portfolio, you may want to choose a few sectors for long-term investing, a few sectors for short-term investments, or a combination of both. For example, some investors believe that technology and health are two sectors that can outperform the broader market in the coming decades.

If this is you, you might choose to add technology sector funds and health sector funds to your portfolio, with the plan of holding onto those investments for the long-term. One example of short-term investing with sector funds is when you shift some portfolio assets while anticipating a recession and bear market.

This is called a "defensive" strategy, and defensive sectors include utilities, healthcare, and consumer staples. Note, this is not the same "defensive sector" that includes arms manufacturers and companies associated with war—those companies are part of what's known as the "aerospace and defense sector."

Use Caution When Investing in Sector Funds

While there is no perfect allocation to assign each sector fund in your portfolio, a good percentage maximum to keep in mind is 5%. This may sound like a small allocation, but it is enough to add diversity to a portfolio and boost returns while minimizing risk. Therefore, if you decide to add three sector funds to your portfolio, each may receive a 5% allocation for a total sector allocation of 15%.

Investing larger amounts in sector funds can add significant risk to your portfolio. For example, biotechnology stocks, a sub-sector of health, have seen incredible short-term gains and some large declines. If you bought too much of a biotech sector fund just before a big decline, it could do significant damage to the portfolio.

Keep in mind that if your core holding is made up of a mutual fund, you're likely to have enough exposure to most or all industrial sectors. Therefore, if you bought enough of a sector fund to represent 5% of your portfolio assets, your overall exposure to that sector could be much higher than 5% due to overlapping holdings with funds you already own.

Bottom Line

Sector funds are not for every investor. Even if you decide that sector funds are a good fit for your portfolio, there are a right way and a wrong way to go about using them. Before buying into one or more of the various industrial sectors, it's a good idea to educate yourself on what they are, how they work, and how they might fit into your portfolio.