Sector funds vs. ETFs
Commentary: Boosting performance through sector funds
By James Lowell, Fidelity Investor Last Update: 1:04 AM ET Oct. 3, 2003 WATERTOWN, Mass. (FidelityInvestor) --

Sector funds have few fans, but several fanatics. With Fidelity being far and away the biggest and most experienced player, sporting 41 sector mutual funds, their decision last month to waive the onerous 3 percent front-end load was surely good news to fans and fanatics alike.

The move make's Fidelity's Select sector funds extremely competitive with exchange-traded funds, where the strongest selling point over actively managed funds was lower cost.

Another key selling point for ETFs, of course, is intra-day trading flexibility -- but, at the end of the day, I keep my eyes on higher returns, and believe firmly that active management, even of sector funds, can make a world of risk- and return-related difference.

It's important to understand, too, that Fidelity sector fund managers are hell bent on outperforming their sector benchmarks -- since that's the only way they'll be able to grab the brass ring from a diversified fund down the road.

Benefits of sector fund investing
Sector funds are among the most misunderstood and misused arrows in any investor's quiver. But, used correctly, most investors can enhance their overall portfolio's return through sector funds. And, compared to trying to pick a handful of stocks on your own, sector funds play a meaningful diversification role, which will reduce risk.

Diversification is straightforward enough: Most sector funds have 50 or more stocks in their mix, meaning that if one or two stocks go south, your overall investment can still move north. That diversification also helps reduce volatility relative to owning a handful of stocks in a given sector.

Moreover, many sector funds have a lower Beta (less risk) than the S&P 500 (SPX: news, chart, profile): A prime example would be healthcare sector funds, such as Fidelity Select Healthcare (FSPHX: news, chart, profile) or Vanguard Specialized Healthcare (VGHCX: news, chart, profile), that concentrate their assets in major pharmaceuticals, medical equipment manufacturers, HMOs, and to a greater or lesser extent, biotechnology stocks.

Less risk, in a necessary long-term growth sector wherein you'll find a basket of real companies, with real products, real market share and, yes, real earnings, can be more fulfilling so long as you invest in reasonable doses.

Before I turn to what I consider a "reasonable dose", there's one caveat that applies to all sector funds: Sector fund investors have to be right about the sector. If not, no amount of stellar stock picking on behalf of the sector fund's manager can save the day.

If, for example, you think that gold is a great sector to invest in, and the market doesn't agree, the sector and the fund or ETF that concentrates in it, will go down.

Reasonable doses
If the S&P 500's weighting in technology is 18 percent, and your overall growth portfolio's weighting in technology is 14 percent, you could invest in Fidelity Select Technology (FSPTX: news, chart, profile) to the tune of 4 percent if you wanted to match the market's bias, or 8 percent if you wanted to be moderately overweight technology relative to the market.

Since technology has already had a significant rally, your portfolio may be overweight tech already, and underweight healthcare, which has performed about half as well as the broader market so far this year.

I'd opt for a combination of Fidelity Select Medical Equipment & Systems (FSMEX: news, chart, profile) and Fidelity Select Pharmaceuticals (FPHAX: news, chart, profile) in equal doses to increase my growth portfolio's overall stake to a moderate market overweight.

Why not use Fidelity Select Healthcare or Vanguard Specialized Healthcare? You could, but both funds own biotech stocks that, like tech, may have seen the best days of their rally's sun.

Sector fund portfolio
Investors can build a diversified portfolio using sector funds. My current Fidelity Sector Investor portfolio (which is independently tracked by Hulberts), is invested in six Fidelity Select funds and one Fidelity Regional fund: Retailing (FSRPX: news, chart, profile), Industrial Materials (FSDPX: news, chart, profile), Brokerage (FSLBX: news, chart, profile), Medical Delivery (FSHCX: news, chart, profile), Networking (FNINX: news, chart, profile), Wireless (FWRLX: news, chart, profile), and Japan (FJPNX: news, chart, profile).

This year, this diversified portfolio is up 15.4 percent through the end of September, according to the Hulbert Financial Digest, vs. a 13.2 percent gain by its benchmark S&P 500 index.

Of course, the year isn't over yet. With that in mind, I'd suggest you take the time in the next week or two to review your current portfolio with an eye toward its sector weightings relative to the market.

Sector funds can help you achieve the weightings you think best.

Shorting Selects

Shorting amounts to owning negative shares in a stock, so that one benefits from declines in prices -- but is likewise hurt by price increases. Basically, if you have a margin account at a brokerage, and it's not an IRA or other such tax-deferred retirement account, you can short stocks or exchange-traded funds.

In general, you can't short a mutual fund. But while Fidelity has rarely promoted the practice -- which it has allowed off and on since the late 1980s -- within a Fidelity brokerage account, it's possible to short some of their Select sector funds.

Of Fidelity's 41 Selects, only 11 can be shorted: Automotive (FSAVX: news, chart, profile), Banking (FSRBX: news, chart, profile), Biotechnology (FBIOX: news, chart, profile), Energy (FSENX: news, chart, profile), Environmental (FSLEX: news, chart, profile), Food & Agriculture (FDFAX: news, chart, profile), Gold (FSAGX: news, chart, profile), Health Care (FSPHX: news, chart, profile), Medical Delivery (FSHCX: news, chart, profile), Telecommunications (FSTCX: news, chart, profile), and Utilities Growth (FSUTX: news, chart, profile).

These were at one time among the largest Select funds, and the most widely held in brokerage accounts.

The shares have to be held in a brokerage account so that you can legally "borrow" them and thereby effectively sell shares you don't own; you return the shares when you buy them back, or "cover" your position, hopefully at a lower price.

When shorting Fidelity Selects, you won't be charged the regular 0.75 percent redemption fee on purchases held less than 30 days. But you will pay a normal stock commission at each end of the transaction, regardless of the time period.

The trade must be done over the phone, not on-line, and the "uptick" rule does apply. (As with a stock, you can't short a Select while it's trending downward; in fact, its latest price has to be at least 2 cents over the previous price.)

If you do want to short sectors, you might want to consider shorting exchange-traded funds instead of Selects. ETFs offer more sectors and other types of indexes (by style, exchange, and international); they're not limited to hourly pricing (unlike the majority of mutual funds, which price once daily, Select funds ; because they're unmanaged index funds you know exactly what they hold; and you can even short ETFs on a downtick -- something you can't do with Selects or individual stocks.

IShares offers the broadest selection of ETFs and a good Web site, www.ishares.com.

Of course, many caveats apply to shorting. Since stocks have unlimited upside potential, there is no set limit to how much you can lose when shorting a stock. (And if you don't maintain enough assets in your account, you may be forced to cover your short at a loss.)

James Lowell edits independent newsletter Fidelity Investor and trading adviser Fidelity Sector Investor. He's also authored several books on investing and is chief investment strategist for Adviser Investment Management.