WHICH SECTOR FUND IS HOT? THEY ALL ARE: ADVISERS LOOKING TO THEM AS A WAY TO BEAT S&P 500; ASSETS AT $100B AS OFFERINGS MULTIPLY LIKE MOSQUITOES

“Sector funds, Benjamin” might be the words whispered in Dustin Hoffman’s ear if “The Graduate” were being filmed today instead of the 1960s.

Thanks in part to some astonishing returns in certain funds as well as financial advisers’ determination to boost their clients’ returns above that of the high-flying Standard & Poor’s 500 stock index, sector funds are rapidly gaining popularity, despite their risky nature and higher fees.

“The push toward sector funds isn’t a fad,” says Marshall L. Schield, president of Schield Management, a Denver-based firm that manages $300 million in assets. “You’ve got all these people out there who cut their teeth on traditional mutual funds and are looking at sector funds as a step up.”

Mr. Schield has $80 million of his clients’ money invested in sector funds, vs. $15 million three years ago.

He’s hardly alone.

Assets in sector funds, which invest in stocks within an industry group, reached $100 billion last year, compared to $41.5 billion three years earlier. Meantime, the number of funds climbed to 463 from 238, according to Lipper Analytical Services Inc. in New York.

So why are sector funds gaining in popularity? Experts say the increased demand is being driven largely by financial advisers, which view the funds as one of their few hopes of beating the S&P 500 – which gained 33.3% last year.

“Advisers are starting to realize that rotating among the different sectors allows them to post some phenomenal numbers,” says Michael Byrum, a senior portfolio manager at Rydex, which serves about 500 registered investment advisers and manages nearly $2 billion.

Advisers also played a crucial role in the success of Meridian Investment Management of Englewood, Colo., which launched 11 sector portfolios ranging from financial services to health care last January.(InvestmentNews, Feb. 23) It signed selling agreements with 150 independent broker-dealers, including Royal Alliance Associates Inc. and SunAmerica Securit
ies Inc. and has already raked in $700 million. Meridian is also peddling the funds through fund supermarkets.

Funds that focus on financial services, a top performer last year, generated the most significant inflows in 1997, growing 140% over the year to $19.1 billion. Assets in real estate funds, another strong gainer, doubled to $12.8 billion, according to Boston-based Financial Research Corp. Other hot sectors are technology and health care and some say utility funds may be gaining steam.

The problem with sector funds is that, by design, they’re not diversified. It’s up to investors, or their advisers, to be in the right industries at the right time, a risky proposition. Sector funds also are more expensive. The average sector fund has an expense ratio of 1.63%, whereas the average domestic diversified equity fund charges 1.43%, according to Morningstar Inc., a Chicago research firm.

Nevertheless, heavy demand for industry-specific funds is attracting new players to the market. In addition to Meridian, Rydex Series Trust, which is based in Rockville, Md., will unveil in April the first of the 14 sector funds it plans to introduce this year.

fidelity offers 38

And Boston-based Fidelity Investments, by far the largest player with more than $18.4 billion in sector fund assets under management and a market share of 18.1%, recently added a fund to its menu, giving it 38 sector offerings.

The nation’s largest fund company plans to launch another sector fund, the Select Medical Equipment and Systems Portfolio, later this year.

“Investors are betting this is a new way to get better returns than the S&P 500,” says Jack Bowers, editor of Fidelity Monitor, an independent newsletter that tracks Fidelity. But that’s not always the case. Investors who poured their money into gold funds, for example, have lost an average of 28% a year over the past 10 years.

Another drawback is that sector funds are fertile ground for market timers and, as a result, are prone to dramatic swings in assets. The cost
s of accommodating sudden redemptions or cash infusions is usually passed on to investors in the form of higher expenses.

The Fidelity Select Consumer Industries Portfolio, for example, climbed to $62.2 million in 1995 from $7.6 million in 1994, only to fall back to $16.5 million in 1996. In each of those years, the fund lagged the Standard & Poor’s 500-stock index by at least 8 percentage points. The fund currently charges 2.27% in yearly expenses.

dumb to hold them

“Sector funds are really set up to be actively managed,” says Linda Ferentchak, a spokeswoman for the Society of Asset Allocators and Fund Timers Inc. in Denver. “You don’t buy and hold a sector fund . . . That’s just plain dumb.”

Performance of sector funds is a mixed bag. While the typical financial services fund rewarded investors with a whopping 45.23% return in 1997, the average natural resources fund returned a dismal 0.06%. All told, the average sector fund posted a return of 20.24% last year, significantly below the S&P 500 stock index.

In fact, sector funds have underperformed the S&P 500 for the past four years, according to Lipper. With such a track record, it’s easy to see why sector funds account for just 3.3% of the $3 trillion invested in all long-term open-ended mutual funds.

The upstart funds join sector veterans like John Hancock & Co., with a 9.4% market share, index fund giant Vanguard Group with 7.7% and J&W Seligman & Co. Inc. and T. Rowe Price Investment Services, each with 5.4%, according to FRC.

One thing working in the newcomers’ favor is their focus on the business, which is a sideline for most larger firms.

“We believe so much in diversification, we are not going to get into very tiny sectors,” says William Shiebler, chief of mutual funds at Putnam, which has two sector funds.”We like to think our portfolio managers in broader funds are able to take advantage of opportunities in certain sectors.”