A reader writes in, asking:
“Under what circumstances would it be advantageous to own one of Vanguard’s sector funds? Their energy fund for instance has done very well over the last 10 years.”
With one exception (which we’ll discuss momentarily), I think few investors have compelling reasons to use sector funds.
The reason why most investors shouldn’t bother with sector funds is the same as the reason why most investors shouldn’t bother with individual stocks. That is, each of the different industries (and most of the individual stocks) that make up the market are already included in a “total market” index fund. So it only makes sense to overweight a particular industry (or stock) if:
- You are meaningfully different from the average investor in some way such that the market portfolio is not a good fit for you personally, or
- You have some information that the market doesn’t have (or doesn’t fully understand) about the industry or stock in question.
For example, with regard to the first point, it would theoretically make sense for most investors to want to underweight the particularly industry that they work in. That is, it would make sense for most investors to have a smaller-than-average allocation to stocks in that industry. The benefit of doing so would be that it reduces the correlation between their job safety and their portfolio performance — thereby reducing the possibility of a particularly bad scenario in which their portfolio tanks at exactly the same time that they get laid off.
In the real world, however, that strategy falls apart due to its impracticality. To create a portfolio that’s market-weighted aside from a smaller-than-average allocation to one industry, you’d have to craft a patchwork portfolio of funds representing each of the other industries. Doing so would result in a lot of extra hassle, additional room for error, and higher expenses (because most sector funds have markedly higher costs than “total market” funds).
With regard to the second point, it’s a bit of a Catch 22. In the rare event that you really do have some information that the market doesn’t have or doesn’t fully understand, there’s a good chance that the reason you have that advantage is because of your work. For example, if you work in the healthcare industry, you might have reason to think that the market is underestimating the future growth of that industry. But the natural conclusion (i.e., to overweight healthcare stocks in your portfolio) is dangerous for exactly the reason discussed above — having your portfolio performance closely tied to your job safety is generally not a good thing.
What about REIT Funds?
Several experts have made the case that, unlike other sector funds, funds owning real estate investment trusts (REITs) warrant an additional allocation beyond what would already be included via a “total market” fund. For example:
- David Swenson makes the case for REITs as a diversifier because their performance is often more closely tied to the real estate market than to the rest of the stock market, and
- Rick Ferri argues that you would need a specific allocation to REITs if you wanted your portfolio to reflect the whole economy (rather than just the publicly traded portion), given that privately owned real estate is such a huge part of the economy.
Personally, I would be happy with or without a specific REIT allocation.