Sector Funds That Make Sense

Investors see the markets as great tools to help them reach their financial goals. For many people, however, the stock market seems no different than a huge casino, letting people place bets on whether companies will succeed or fail. The recent upswing in specialized sector funds and exchange-traded funds has only reinforced that impression by giving speculators an easy way to gamble on certain groups of stocks.

However, sector funds can play a useful role for long-term investors. As this month's issue of the Fool's Champion Funds newsletter points out, buying the right sector funds can help you diversify your portfolio into areas where your other investments don't give you much exposure.

Finding new frontiers
If you own a broad-based large-cap mutual fund -- whether it's an index fund or actively managed -- you already have a foot in the door for most sectors of the market. An S&P 500 index fund, for instance, gives you about 20% exposure to technology, 17% to financial stocks, 14% to energy, and 12% to health-care stocks.

However, there are several sectors of the market that broad-based mutual funds tend to neglect or underweight. For example, you'll find more than 30 utility stocks in the S&P 500 -- including Exelon (NYSE: EXC  ) and Dominion Resources (NYSE: D  ) -- but together, they make up only around 3% of the index. Similarly, even though real estate-related investments performed extremely well for many years, REITs like Simon Property Group (NYSE: SPG  ) and ProLogis (NYSE: PLD  ) constitute only about 1% of the S&P 500.

If you want to increase your exposure to sectors that are underweighted in your mutual funds, sector funds make it easy. There are dozens of funds focusing on utilities and REITs, and if your own portfolio is missing stocks in some other sector, you'll usually be able to find a specialized fund that will help you fill in the gaps.

Covering your bases
The other important use of sector funds comes when you like a particular industry, but you're not entirely sure which companies will benefit you the most -- or you want broader coverage than just a few stocks will give you. For instance, with increasing demand from China and other emerging markets in recent years, the steel industry has undergone a renaissance, providing excellent returns for investors.

If you believe the trend toward increased steel usage will continue, you could simply buy shares of large producers like U.S. Steel (NYSE: X  ) and Cleveland-Cliffs (NYSE: CLF  ) . But with steel becoming a global industry, you might be picking the wrong players if foreign steelmakers like ArcelorMittal (NYSE: MT  ) become the dominant forces in steel. A sector fund like the Market Vectors Steel ETF would give you a stake in 30 different steel companies, letting you benefit from strength in the industry without having to guess which company will do best.

Pick the best sector funds
As with any fund investment, it pays to focus on fundamentals in selecting a sector fund. Fees span a wide range, depending on whether you go with a passive index-based ETF or an actively managed fund. Looking at managers' track records is also important, although you should also be careful not to chase performance in a particular sector that happens to have done well recently.

It's true that sector funds let people make big bets on short-term movements in markets. But that doesn't mean they can't serve a useful purpose in your portfolio as well. Used properly, sector funds can help you beat the benchmarks and make your portfolio even more diversified.

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