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Should I Own Any Sector Funds?

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.

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  1. With regard to REITs, if you own your own home like I do, then you already have significant portion of wealth invested in real estate.

  2. Excellent point, rjack.

    In fact, I recall one of Vanguard’s executives (at Vanguard’s “ask the experts” panel at the 2011 Bogleheads conference) stating that one reason there’s no REIT fund allocation in their target retirement funds is precisely what you stated — many people already have a significant allocation to real estate via their home ownership.

  3. There is a difference between real estate as a homeowner and as an investor. I do hold some REIT ETF through Schwab. I figured real estate should have been close to the bottom and would be climbing. The ETF also diversifies risk across geography and sector.

    I also own some individual stocks. Mainly ones that have a very long track record of growth and dividends. I decided I liked the additional punch a larger holding in those could provide then just holding the EFT. Of course, the larger loss, too, but so far so good. :O)

  4. I like to split my portfolio into different funds for the different components so I can make a little more money with re-balancing (selling high to buy low). Ideally I’d split it up based on sector, but sector funds cost way more than other funds, so I do it by large vs. small, stocks versus bonds, and US vs. European vs. Asian vs. emerging.

    I do also have a REIT fund, mostly because of its relatively low correlation with the rest of stocks and bonds.

    I do own my house, which is nearly 1/2 of my total net worth, but I also think of it differently. It’s sort of like a fund that pays whatever current rents are minus taxes and repairs. So having a house just keeps me from having to pay rent. And if my property taxes get so high I can’t afford them, it probably means my house is worth a lot and I could sell it and use the proceeds to move somewhere cheaper.

    Even if I’m kidding myself and my house really should be considered a part of my portfolio, it is not diversified at all. My entire house holdings are in one locale and one type of property (single-family dwelling), so a REIT or REIT fund would still help with diversification.

    Similarly, my pension will be sort of like a bond, but an additional bond fund helps with diversification (what if my state goes down?) and helps me profit from rebalancing.

    Similarly, if someone has their own business, that’s like a stock, but additional stocks help with diversification.

  5. If I work for the government, then I should underweight government bonds?

  6. George,

    That’s an interesting question. At the federal level I wouldn’t worry about it. But if I were a state/local government employee, I would certainly have some hesitancy about loading up on muni bonds from the same governmental entity.

  7. I have a large amount of my net worth in both residential and tenanted property but I also have 10% of my pension invested in commercial property via stocks and a Vanguard tracker for diversification.

    A very interesting point from Mike above about Vanguard purposefully not including REITs in their target funds. I do think that residential and commercial property are different assets, although obviously correlated.

    While we have done well out of residential property, we have no plans to move again so I see our house as a LTBH investment. Disposing of it may well be a source of revenue but I don’t factor this into my equations yet and hopefully will never need to.

    Tenanted property is more interesting and is effectively a geared investment linked to rental income and capital values. Over time the gearing should reduce and eventually it will become hopefully a high-yielding asset with some potential capital appreciation. In both cases I guess I’m doubling up against the property in my pension plan, but I still think commercial and residential have significant differences.

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