Sector Appeal: Funds That Beat Indexes

By JANE J. KIM


If you expect small stocks to outperform for a while, consider an actively managed sector fund instead of an exchange-traded fund that simply tracks an index.



Actively managed funds have either tied or beaten ETFs in eight of the 12 major sectors so far this year, according to Morningstar Inc., and investor dollars flowed in. During 2009 and January of this year, net flows into actively managed sector mutual funds outpaced flows into sector index funds, according to research firm Strategic Insight. That follows several years where the reverse was true.



The active managers are making inroads in part because they have more flexibility to buy small and midcapitalization stocks, which are usually among the first to rally in an economic recovery. By contrast, many indexes are composed of stocks that are weighted by market capitalization, so they tend to be made up of the largest companies whose performance has recently trailed.



"There are periods of time when it's easier to beat indexes and periods of time when it's hard to beat indexes," said Brian Hogan, president of Fidelity Investments' equity group. "It's just a very opportunistic time for active managers."



Fidelity, which manages $42 billion across 71 sector funds, is a case in point. Its sector funds are outperforming ETFs in eight of 10 key sectors for the trailing three-year period—a result the company attributes in part to its recent investments in research.



How long will it last? At least a little while longer, say some experts. Historically, small-cap stocks fare better than large-cap stocks during the first two years of a bull market, said Sam Stovall, chief investment strategist at Standard & Poor's Equity Research.



Another wild card that could extend the small-cap rally is Greece. If the problems there spill over into other countries and the euro continues to weaken against the U.S. dollar, that could hurt larger companies which typically have greater international exposure and make small-cap stocks a better shelter, Mr. Stovall said.



Sector funds aren't for everybody. The funds tend to be volatile. Investors often end up going into a hot segment after most of the gains already have been made. High fees and high turnover also can eat away at returns, making index funds' low fees and tax efficiency a better option for many investors. The average actively managed sector fund has annual expenses of 1.66%, compared to 0.57% for a sector ETF, according to Morningstar.



Nevertheless, some actively managed sector funds may be worth a look in today's market. "If you're looking for a sector fund, you want to get a really good manager—a specialist in the area with a long-term track record, or a firm that's really dedicated to that space," said Russel Kinnel of Morningstar Inc.



Here are some managers who fit that description:



Energy. Dan Rice, who runs BlackRock Inc.'s BlackRock Energy & Resources Portfolio, has been at the helm since the fund's inception in 1990, making him one of the longest-serving managers in the energy and natural-resource categories. Unlike many of his peers who focus on the bottom-up characteristics of their stock picks, Mr. Rice, along with co-manager Denis Walsh, focuses on long-term supply-and-demand trends to forecast commodity prices. "About two-thirds of performance is getting the commodity price correct," Mr. Rice said.



Though the fund is one of the category's most volatile because it holds many small companies, it also is one of the sector's best performing. It averaged a 23.6% annualized gain after fees over the trailing 10-year period ended Feb. 26, according to Morningstar. "This is a strategy in other people's hands we'd consider quite risky, but time and time again, he's proven successful with it," Morningstar analyst Michael Herbst said.



Financial. Kenneth Charles Feinberg, who has been running the Davis Advisors' Davis Financial Fund since 1997, likes to buy companies that are operating under a cloud and hold them for several years. "We're going to own companies and not going to rent companies," he said. Although the fund lost 46% in 2008—in part because of the overall decline in financials and its AIG holdings—it posted a 10% annualized return over a trailing 15-year period, making it one of the category's top performers, according to Morningstar.



Health Care. Ed Owens uses a value-oriented, buy-and-hold approach to manage Vanguard Group's Vanguard Health Care Fund since the its inception in 1984. "I normally ask myself what are investors going to be talking about in our stocks a year from now," he said. "Evaluating fundamentals is 80% of how we spend our time."



Although the size of the $20 billion fund limits Mr. Owens's and co-manager Jean Hynes's ability to invest in smaller-cap stocks, they have a significant exposure to mid-cap companies and have been able to find opportunities in non-U.S. companies, which make up 25% to 30% of the fund. The fund also boasts rock-bottom annual expenses of 0.33%, although some investors might balk at the $25,000 minimum investment.