The Sector Report

The Sector Report

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ector frenzy. It seems to really be catching on. And it's not just investors doing it, but fund purveyors too. As observed in "The Tech Wreck" (Financial Planning Magazine, August 2003) a sizeable batch of new funds tend to roll out in sectors which are enjoying (or have enjoyed) some success only to reward late-comers with a less than enjoyable entree experience. The tech sector proved to be a quintessential example of such a scenario from 2000-2002 (see Figure 1). As the number of new technology funds was spiking the returns of the sector were plunging. Annual returns were determined by the average of all tech funds that had at least a full 12 month return.

The thesis of this article is simply this: Whereas systematic and strategic reallocation among a pre-defined set of fundamental asset classes can be advantageous, sector chasing will not likely be -- particularly if the sector being chased is the one in which a lot of new funds are appearing.

Evidence abounds supporting the notion that investors and fund companies focus on short-term performance in an equity arena that could be aptly described as a "benchmark-of-the-week battlefield". The search for hot spots of return has focused money management microscopes ever more finely -- which has had the effect of magnifying sector fever. Additionally, the proliferation of niche equity benchmarks more or less prods mutual fund companies to pump out portfolios designed to mirror them…or better yet, beat them. These, and other forces, have created a climate in which the number of sector funds has mushroomed during the past 10+ years.

As shown in Figure 1, nearly 75% of all sector funds in existence as of 12/31/03 were launched on or after January, 1994. Technically, the total of 297 new sector funds since 1994 represents distinct funds (the term distinct indicating that only the primary share class is included in this total) which had at least a 12 month return as of 12/31/1994. Thus, a sector fund launched in mid-January 2003 is counted as a new fund in 1994 inasmuch as 1994 represents its first full calendar year return. Raw data on sector funds were obtained from Morningstar's Principia software. Morningstar has historically categorized eight separate equity sectors: Communications, Financial, Health, Natural Resources, Precious Metals, Real Estate Investment Trusts (REITs), Technology, and Utilities.

In the sector fund proliferation race technology funds are the winner, just edging out REIT funds. Eighty eight percent of all tech funds were brought to market since 1993, compared to 85% of all REIT funds. The bronze medalist is the health sector, where 78% of all health funds are new since 1993. The bulk of the growth in the number of tech and health funds has taken place since 2000, whereas the growth spurt in the number of REIT funds took place in the late 1990's. The fourth most prominent sector fund category are financial funds, 30 of which are new since 1997. Remember, these numbers reflect only distinct portfolios. These four sectors (technology, REIT, health, financial) represent 84% of all the funds introduced since 1993 and 75% of all sector funds in total regardless of date of inception.

Now, on to an intriguing observation. The rapid growth in the number of tech funds in 1999 and 2000 (as measured in 2000 and 2001 by new funds with at least a full 12 months of return) coincided with two very bad years of return (in pink). In fact, the arithmetic average return per year during 2000-2001 was about -32%. Here's the real point: the two years prior to the growth spurt in the number of funds (1998-1999) produced an arithmetic annual mean return of 97% (Figure 2).

The same pattern, though not as dramatic, is discernable among REIT and health funds. Among REIT's the build-up in number of funds was 1998-1999 which coincided with a two year average return of -8.4%. The two prior years (1996-1997) the average return among REIT funds was 27.8% (Figure 3). Finally, among health funds, 2001-2002 saw 29 new funds added and, sadly, a two year average annual return of negative 20.2%. During the two prior years (1999-2000) health funds averaged just over 38% per year (Figure 4).

Is it just us, or is there something of a pattern here? Big returns in sector…run up in number of funds a few years later…new funds hit the street a year or two later just in time to get hammered…investors swear off that sector and chase another…and déjà vu all over again.

Frankly, the pattern has a couple of systemic characteristics; first the performance numbers materialize, many times followed by an influx of money to the existing players, next, fund company marketing departments notice the increased patronage of their competitors and finally the cumbersome legal and organizational efforts have to be completed - and magically a new sector fund is born. But alas, just in time for the last dance.

Note: in recent years we've also witnessed an elimination of some funds. This usually happens on Wall Street during business contractions. Funds are merged or closed and their track records go with them into oblivion. Do you suppose there is a correlation between net fund shrinkage and subsequent period performance? Makes you think. Stay tuned.

Does all this suggest that investing in sector funds is a bad idea? Not at all. The point is that sector funds may experience a more dramatic version of cyclical whiplash given their inherent lack of diversification. However, when sector funds are placed within a correlation-based portfolio their volatility can be harnessed and serve a very useful purpose. The main message of this analysis is that jumping into a sector when a lot of new funds are showing up is probably a very bad idea.

Figure 1. Sector Scoop

Figure 2. Tech Sector Funds

Figure 3. REIT Sector Funds

Figure 4. Health Sector Funds

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Craig L. Israelsen is an Associate Professor in the Department of Consumer and Family Economics at the University of Missouri-Columbia (http://www.missouri.edu/index.cfm) where he teaches courses in Personal Finance and Family Living. He holds a Ph.D. in Family Resource Management from Brigham Young University. He received a B.S. in Agribusiness and a M.S. in Agricultural Economics from Utah State University. Primary among his research interests is the analysis of mutual funds. He writes monthly for Financial Planning magazine.

Eric Park, CFP, CFS, PhD candidate University of Missouri.