Technology sector funds led the stock market's fourth-quarter rally, but they still finished 2001 with an average loss of 38.3%--the biggest decline of any major fund category last year.
Communications sector funds had almost as bad a year, losing 34.6%, on average, according to Morningstar Inc. data.
And utility sector funds, once thought of as an investing haven for widows and orphans, tumbled 21.2% in 2001, thanks in part to the hard-hit telecom stocks many of them hold.
Investors who got used to big winnings in sector stock funds in the 1990s found out last year just how risky these narrowly focused portfolios can be.
Yet some financial advisors say sector funds still can be an effective tool for short-term traders, as well as a good idea for buy-and-hold investors, if used properly.
Despite a 13.4% loss last year, the average health-care sector fund has rewarded long-term investors with a gain equivalent to 15.2% a year over the last five years, according to Morningstar. That far exceeds the 9.1% annualized gain of the average domestic stock fund in that period.
Sector funds allow investors "to play offense or defense, or simply to fine-tune the investment mix," said Jim Lowell, editor of the Fidelity Investor newsletter in Potomac, Md., which analyzes the mutual fund giant's 41 sector funds, as well as its other offerings.
"One advantage of sector funds is that they allow you to finely parse the investment universe," Lowell said. For example, if you have significant faith in a particular industry but aren't sure about the best individual stocks to play, you can use sector funds to make a bet on the industry without limiting yourself to a particular stock.
Sector funds are big business for many fund companies: The combined assets of eight major stock sector fund categories tracked by Lipper Inc. total about $180 billion. By contrast, diversified small-stock funds hold about $150 billion in assets, according to Lipper.
Because sector funds concentrate on stocks within one industry or a cluster of closely related industries, they tend to be highly volatile, naturally gyrating with the fortunes of that segment of the economy.
Short-term traders can capitalize on that volatility by trying to ride hot sectors with a portion of their money, said Paul Merriman, head of Merriman Capital Management in Seattle and editor of the newsletter FundAdvice.com.
Merriman recommends spreading money earmarked for short-term sector investment among four fund sectors at a time to limit the risk. His strategy is to play those sectors that have the strongest share-price momentum in the last 100 trading days.
But investors trying to play short-term market moves obviously has to stay fast on their feet, experts say.
"The problem with sector investing is that it's not just important when you get in, but also when you get out," Lowell said. "If you're not careful you can end up like Jimmy Cagney [in 'White Heat'] screaming, 'Made it, Ma! Top of the world!' while the natural gas tank under you is about to explode. You have to be much more vigilant than with a diversified fund."
Merriman said many of the traders who follow his recommendations adjust their sector portfolios daily or weekly rather than monthly, for example. As he put it, "A lot of bad stuff can happen to an industry in 30 days."
Because of the potential for extreme ups and downs, sector investing demands discipline if you're a short-term trend player.
"You must be willing to cut your losses short and to go back into a sector at a higher price than you got out at" if the trend turns positive again, Merriman said. "In other words, you have to admit mistakes, which some people can't do."
For short-term traders, Merriman recommends using sector funds from Rydex or ProFunds, which carry no upfront sales fees and no redemption charges. (Fidelity Investments' Select sector funds, by contrast, which carry a 3% front-end sales charge and a redemption penalty if sold within 30 days, are geared toward longer-term investors.)
For true daredevils, ProFunds offers funds designed to perform at roughly 1.5 times the underlying sector--up or down--on a daily basis, by using borrowed money to amplify their bets.
As of last week, Merriman, whose fund picks are available free via e-mail service from the Web site SoundSectorStrategy.com, suggested ProFunds customers be invested in ProFunds Ultra Technology, ProFunds Ultra Semiconductor, ProFunds Ultra Basic Materials and ProFunds Ultra Real Estate, and that Rydex customers own Rydex Precious Metals, Rydex Consumer Products, Rydex Biotechnology and Rydex Basic Materials.
Looking forward six to nine months, Lowell said one of his intermediate-term sector recommendations is a defensive play: He recently upgraded Fidelity Select Gold as "a hedge against the Fidelity Growth Company fund in times of geopolitical uncertainty."