One Sector Does the Trick

04/08/2010 4:05 pm EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Daniel Wiener, editor of The Independent Adviser for Vanguard Investors, recommends an actively managed portfolio with a distinguished history.

When it comes to investing in very discrete sectors of the stock market, your results can be profitable, unprofitable, or downright ugly.

That isn't to say you can't make money in sector funds. You can. And when you're in the "right" sector at the "right" time, you feel like the world's biggest investment genius. The opposite is also true.

For the most part, I've cautioned against being an active sector investor unless you have a very well-conceived strategy guiding you—or focus, as you and I have, on one excellent sector, health care, and an excellent team at Wellington Management, running an exceptional fund, Vanguard Health Care (VGHCX), or the equally exceptional Hartford Global Health (HGHAX), which I recommend as an alternative if you can buy it without a load.

I took a look at historical data for all 11 of the sector indexes, courtesy of MSCI. My first cut was to consider which of the sector indexes outperformed the stock market over rolling one-year, three-year, and five-year periods by analyzing more than 440 discrete performance periods for each index. From a performance standpoint, if you can't beat the market, why make an investment (as opposed to a timing bet) on a sector of that market?

Only seven of the sector [indexes] make the first cut—Consumer Staples, Energy, Financials, Health Care, Industrials, REIT, and Utilities. So, seven of the 11 indexes have, on average, generated market-beating returns over multiple rolling time periods. Four haven't.

But returns are only part of the equation. As you know, I'm a big believer that investors get into trouble when they pray at the returns altar while ignoring risk. When I look at the worst losses suffered by these indexes over any one-, three-, or five-year period, I am immediately scared off by the financials, industrials, and REITs. It's not that these sectors haven't had bright moments in the sun, but when the weather gets cloudy for these market sectors, it gets really dark.

So, from 11, we're now down to just four sector indexes worth considering as long-term investments: Consumer staples, energy, health care, and utilities.

[Now], let's go back to my first and most important piece of advice. When it comes to sector index funds, most investors should generally avoid them. I prefer an active manager on a Vanguard sector fund.

One factor in Vanguard fund managers' ability to outperform their peers is, of course, their funds' low expense ratios. It's always nice to have a lighter headwind than your competitors. But they also have done well against Vanguard's index funds, which are some of the cheapest available. Vanguard's active [sector] funds,…Health Care in particular,…[have] outperformed the market handily. (Vanguard Health Care closed Wednesday at $122.49—Editor.)

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