Which mutual funds employ a sector-rotation strategy?

QUESTION: Which mutual funds employ a sector-rotation strategy?

-- Thomas Mayton

ANSWER: Being in the right sector at the right time is a fabulous idea, isn't it? Just think: You could have held, say, a hearty dose of real estate in 2001 (when the average fund gained 9.42%), financials in 2000 (average gain: 27.43%) and tech in 1999 (average gain: 133.96%). You could, in short, be one very rich investor.

You'd also have to be a very talented market timer, since consistently getting in on the beginning of a hot sector trend is no easy task. Nevertheless, the idea is so appealing (particularly in this dreary market) that there are many newsletters and, yes, a few mutual funds, dedicated to the task. "I know that it can work, but the pitfalls are dramatic," says Jim Lowell, editor of the Fidelity Sector Investor newsletter.

These days there are at least two funds that employ a top-down sector-rotation strategy, meaning they make broader sector bets before they pick specific stocks. They are the T. O. Richardson Sector Rotation fund (TRSRX) and the new Rydex Sector Rotation Fund (sorry, no snapshot), which launched a little over three months ago. Both of these quantitative funds use a price-momentum strategy to evaluate which sectors are gaining the fastest (and which are losing steam), although their specific methodology varies. Over the past three years, the T.O Richardson fund has an annualized return of -6.01%, compared with -8.25% for the S&P 500.

Another fund that bills itself as a sector-rotation fund is the Icon fund (ICNIX), although this quantitative fund uses a bottom-up investment strategy (meaning it picks the companies it likes before it evaluates the sectors they reside in). Nevertheless, since this fund operates on the premise that the market is subject to industry and sector "themes" that typically last one to two years, certain sectors are overweighted or underweighted to take advantage of market conditions. Unlike the funds described above, this fund takes more of a value approach (combined with a relative strength component), moving out of stocks and sectors that its managers perceive as overvalued, and into ones that are undervalued based on an intrinsic-value equation. It also has significantly less turnover: 28%, compared with a staggering 743% for the T.O. Richardson fund.

So does a sector-rotation fund belong in your portfolio? At least in theory, there are some advantages to purchasing a fund that will rotate among sectors for you, rather than attempting to do this on your own. The most obvious one is that you don't have to be glued to the market, making some sort of assessment as to which sectors are poised for gains. Also, by purchasing a mutual fund, you won't have to worry about racking up hefty trading fees (one of the problems with sector-rotation strategies), although you should keep an eye on fund expenses. Nevertheless, in practical terms, you should be wary of investing in any fund without much of a track record, and of this crew, the "granddaddy" is the T.O. Richardson fund, which was just started at the end of 1998.

It's also a bit tricky figuring out where a sector-rotation fund belongs in a portfolio, particularly if you're a long-term holder of other individual sector funds. No matter what, these funds should not be treated as core holdings, says Russ Kinnel, director of fund analysis at Morningstar. Among other things, that means that, as with other sector funds, you shouldn't allocate more than 10% of your portfolio to these investments. You should also consider how your overall portfolio would be affected should your sector-rotation fund be heavily invested (even temporarily) in sectors that you already hold in your portfolio.

Also keep in mind that any fund with massive turnover may not be tax-friendly. So if you do decide to go with a sector-rotation fund that trades rapidly, you may want to hold it in a tax-advantaged account, like an IRA. But if you're anywhere near retirement, you should be fully aware of the volatility of these funds. The standard deviation (a measure of risk) of the T. O. Richardson fund is 25.33, while the S&P 500's is 16.10. Volatility is simply something that comes with most sector funds.

Bottom line? While the premise of sector-rotation funds is interesting, "there have been a lot more people who have succeeded at fundamental stock selection than top-down sector calls," says Kinnel. And combining a volatile investment strategy with a short-term track record is risky business indeed.