FOOL ON THE HILL
Sector-based stock mutual funds are Wall Street's effort to soothe you with groupthink and take your money. With biotechnology as an example, it's clear that they are marketing ploys only and offer the investor nothing positive for investing. Either you have the time to choose individual stocks, or you should stick to a broad market index fund.
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Today's theme: to show that any reason for investing in sector stock mutual funds is wrong. These funds have multiplied like excuses for missing deadlines. "Retail, software, energy, food, wireless, biotech -- we've got a sector for your needs and any market." Leave it to Wall Street's marketing divisions to find another ploy to separate you from your wallet. One piece of advice: Refuse, resist. There is simply no good reason for an investor -- as opposed to a trader -- to prefer a sector fund to individual stocks or our favorite, the broad market index fund. Repeat: Just Say No. Sector funds are groupthink Nay, nay, don't bother to ask, "what is software, anyway?" Or, "Are all financial services firms created equal?" Just close your eyes and buy, pay the load and/or high expenses, and let them do the driving. Folks, that's groupthink. Popularized by George Orwell in his brilliant and sadly prescient novel, 1984, it describes a group that accepts, rather than questions, any decision or tenet. In the investing world, mutual fund companies sell so-called sector products based on groupthink. The so-called sectors are labels designed to take advantage of what's hot in the financial media, whether it's in a bull market ("Wireless! Internet!") or a bear market ("High Yield! Gold!"). Individual stocks or broad market index fund If you're not up for that, buy a low-expense, broad market index fund. No ifs, ands, or buts. Apart from the fact that most mutual funds -- anywhere from 70% to up to 90%, depending on your research study -- fail to outperform the S&P 500 index over five years or more, sector groupthink is absolutely contrary to sound investing. But let's allow individual investors the benefit of the doubt for a moment, and say that it makes sense to buy a sector fund if you think a particular industry might profit across the board. What happens if the sector is a meaningless label and there is no industry at all? What if the companies the sector funds actually buy are so diverse that the rationale of profiting from a group is rendered laughable? I know that several of my colleagues have written favorably at times about sector investing, including open and closed-end sector funds (such as biotech) and exchange-traded funds such as Merrill Lynch's (NYSE: ML) HOLDRs. They're smarter than I am, so they're probably right. But I stubbornly maintain that my core argument -- that a marketing label does not equal an opportunity for profits across-the-board in an industry -- applies to those funds as well. Biotech is no sector One of my favorites is biotechnology. What a label that is. Sounds good, but what does it mean? (We help you learn about this through our InDepth: Biotechnology page.) To save time, let's consult the Columbia Encyclopedia: "... the use of biological processes, as through the exploitation and manipulation of living organisms or biological systems, in the development of manufacture of a product or in the technological solution to a problem. As such, biotechnology is a general category that has applications to pharmacology, medicine, agriculture, and many other fields." That definition alone should disabuse anyone from thinking that a biotech fund is anything but a marketing scam. What is a biotech company, after all? If it's any company that uses biotechnology, that's hardly a basis for determining that there will be profit across all of those companies. Hey, we could pick companies that use the Internet or the telephone or computers. Wow, there's an idea! Nope, biotechnology is a technology, not an industry. So with no real industry sector here, what do biotech fund managers do? I took five mutual funds with the name "biotechnology" in the title and looked at their top 25 holdings through Morningstar. The funds are Dresdner RCM Biotechnology (DRBNX), Franklin Biotechnology Discovery A (FBDIX), Rydex Biotechnology (RYOAX), Fidelity Select Biotechnology (FBIOX), and Alliance Select Investor Biotechnology (ASBAX). Two results: These biotech funds more or less choose the same stocks for their top 10 holdings, showing their own groupthink (and making me wonder how anyone would pick one over the other). Yet these holdings, and the rest among their top 25, provide little support for any argument that this or that group would benefit jointly. Their holdings do not define an industry. Biotech fund groupthink This is hilarious. Sure, if you looked at the whole list, they would have 53 companies in their top 25, and even more beyond that. But these managers invest 40% to 62% of their funds in the same 15 companies. The top include Amgen (Nasdaq: AMGN), Genentech (NYSE: DNA), and Biogen (Nasdaq: BGEN), all first-generation biotech drug makers. Because of their weighting in the portfolios, they will represent the largest movements in the fund's value, but their individual performance will still be diluted by all the other holdings anyway. You might as well buy these yourself, because that's more or less what you're getting, watered down. You'd do just as well as -- and probably better than -- the fund, and not pay the funds' expenses. Not an industry at all You don't even need to be a biotech expert to see this odd diversity. Go to any source for a description of the company's business, and you'll find the following for companies in the funds' top 25 holdings: The diversity of markets here is astounding. A few are already large drug makers, but others want to be, and few of those have the resources to do it. Some, like Applied Biosystems (NYSE: ABI), Affymetrix (Nasdaq: AFFX), or Invitrogen (Nasdaq: IVGN), in their wildest of dreams will at most sell to a specific, limited market that with competition, and the end of the biotech financing boom of the last several years, will have static or declining businesses for some time to come. The diversity of risk is also astonishing. Most would think "biotech" is probably risky, but why would anyone want a portfolio with this broad a range, when the goal is to profit from a group of companies you think will do well because of business conditions for an industry? I repeat: What basis is there for thinking that these companies will all somehow profit from investment in "biotechnology"? The prospects of individual companies are what count, and lumping them all together is just a marketing plan to get your money. End sector fund groupthink today Individual stocks or broad market index funds. That's the choice. End of story. Tom Jacobs does not own any of the companies mentioned in this article. His stock holdings can be viewed online, as can the Motley Fool's disclosure policy.
The goal of sector funds is to encourage investors to buy sector funds as a way to profit from a group of supposedly related businesses, foregoing the risk from singling out one or more individual companies. The pitch: "Health care will profit! Fill 'er up. Telecom's the future! We got it. Software? Real estate? Get your across-the-board winnings here!"
There is a simple rule for investing in stocks. Either you have the time, energy, and expertise to learn about individual companies -- their management, financials, products, and prospects -- or you don't. If you do, gather information from as wide a variety of places, ranging from the required reading of the company's latest SEC Form 10-K, your investment club, and stock discussion boards (exercising great critical faculties about what you read, as always), as possible. Identify a limited selection of stocks reflecting your financial goals and tolerance for risk, and buy them. We've never said it was easy, but it is simple.
Let's take just one popular sector to illustrate the perils of hoping to profit from a sector -- a group -- only to find that growth is unlikely to spread across the group in some way that might conceivably justify the choice of the fund.
Some results:
The choice of companies appears designed to make the investor think this is "biotech," but it fails to define an industry that might encompass companies poised to profit in general. Beyond the 15 companies they all more or less buy -- companies not in the same business, by the way -- it's open season, with 38 more diverse companies that are owned by three or fewer of the funds.
You would probably find the same results in any selection of sector funds: The managers would agree on most of the top holdings, but those holdings, as well as the rest of the portfolio, would likely indicate that the fund would not profit in general from business conditions that you might think would benefit the sector.
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