Welcome to the latest installment of our weekly fund review, in which we scrutinize the past week's notable fund news and tell you what it means for Foolish investors.

Sector ETFs run into trouble
Sector-based exchange-traded funds have gotten a great deal of investor attention and money in recent years. In response, dozens and dozens of these funds have flooded the market, each focusing on a narrow sector or industry. However, as market volatility has risen in recent months, many of these ETFs have hit a barrier.

ETFs that focus on homebuilding and private equity have been hit particularly hard. According to AMG Data Services, the iShares FTSE NAREIT Mortgage REIT (NYSE:REM) ETF is down 37% since its inception four months ago, with big losses from Thornburg Mortgage (NYSE:TMA) and Rait Financial (NYSE:RAS) partially to blame. Investors have responded by pulling $11 million from the fund during that time. A similar housing fund, the State Street S&P Homebuilders (AMEX:XHB) ETF, has lost about 30% of its value in the past three months holding stocks like Beazer Homes (NYSE:BZH) and Standard Pacific (NYSE:SPF). Weekly outflows for this ETF have hovered around $110 million since mid-July.

It shouldn't be surprising that such narrowly focused funds experience wide swings in performance. By investing in these narrow segments of the market, investors expose themselves to far more volatility than they would by investing in a diversified fund. While sector-based funds do have the potential to post double-digit gains in a relatively short time frame, as the two examples above show, they can swing into seriously negative territory just as easily.

Most investors have no need for sector-based funds, no matter which area of the market the funds focus on. Diversification should be one of the highest priorities for any mutual fund investor, and it's sorely lacking in sector funds. Stay away from these types of ETFs and invest only in broad-market, well-diversified funds. This way you can avoid the widest of the swings in the market and sleep more soundly at night.

401(k) plans favor actively managed funds
The debate between active and passive investing is an old one. Those in favor of indexing argue that most managers can't beat the market anyway, so it's better just to match the market rate of return. Index funds can offer investors a much cheaper way to get exposure to the stock market. But when it comes to 401(k) investing, more and more plans are choosing to add actively managed funds to their menus.

A recent Wall Street Journal article reported that between 1999 and 2002, only 11% of funds added to 401(k) plans were index funds. And even when index funds are offered, investors show reluctance to invest in them. A separate survey done by Vanguard Group showed that of all the plans the firm provides recordkeeping services for, only about half of participants chose a U.S.-stock index fund, despite the fact that almost all of the plans offered such an option.

It's unclear why plan sponsors and participants appear to prefer actively managed funds. A story by fellow Fool Dan Caplinger suggests that plan sponsors are to blame, actively trying to rip off employees. Yet sponsors could easily argue that they're only giving participants what they want, especially in light of the Vanguard survey.

What to do
Here are a few points that 401(k) investors should keep in mind. First, if you choose to invest in one or even several actively managed funds within your 401(k), make sure you know how much you are paying to do so. Actively managed funds are typically more expensive than index funds, so keep an eye out for excessive fees that will eat away at returns.

Second, don't automatically assume that the addition of actively managed funds to your 401(k) menu means that your employer endorses these particular funds and their investment strategies. A plan sponsor is obligated to provide an array of funds appropriate for many investors at different stages in their investing career, but you still need to take responsibility for choosing the best options.

Both active and passive funds have advantages and disadvantages, so be sure you understand those pros and cons before investing. Whether someone should be a passive or active investor depends largely on individual preferences and the general outlook of the market.

Know yourself and your portfolio goals, and you'll be much more equipped to make correct investing decisions within your retirement plan.

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Fool contributor Amanda B. Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned. The Fool has a disclosure policy.