Financial Funds Provide Diversity ... And Risk

"Focused diversity." How's that for an oxymoron? But that's exactly what sector funds try to provide by bridging the gap between individual stocks and broad index-based mutual funds and exchange-traded funds (ETFs). These funds let you pick an individual sector in which to invest, and avoid some of the company-specific risk that comes with picking individual stocks. But which sector should you pick? This article will examine sector funds that invest in the financial industry and the advantages and disadvantages that securities in this sector can present to investors. (To begin with the basics, see An Introduction To Sector Funds.)

Why Invest in Financial Sector Funds?
The financial sector is more than credit products and savings accounts. This sector encompasses investments, insurance, mortgages, banking, derivatives, venture capital, accounting and it is also intertwined with real estate. It is an industry essential for the economic wellbeing and financial strength of a country. (For more information on this sector, see The Evolution Of Banking.)

Financial funds provide easy market participation for investors whose portfolios lack exposure in this sector. They can also provide a greater measure of diversification within the financial industry than may be otherwise possible. Some financial mutual funds focus on specific subsectors of the financial industry, such as banking or mortgages. Others cover a broader spectrum and invest in either several or all of the subsectors within the industry.

To diversify most efficiently, planners should carefully examine possible overlap between any potential sector fund and the client's current portfolio, so that any financial fund that is chosen contains the fewest possible stocks that are already held by other funds owned by the client. For example, the stocks of major financial conglomerates are often found in many mainstream growth and/or growth and income funds, and therefore more specialized financial funds that invest in specific subsectors may diversify the client more efficiently. (For more on managing your investments' exposure levels, check out Introduction To Diversification.)

Historical Performance
The financial sector essentially reflects the economic activity of the rest of the world. In a sense, the rise and fall of all other sectors both domestic and international have a direct impact on the performance of this sector. This is reflected in both the Morningstar Financial Services Fund Index from 2003-2008 and the Standard & Poor's Financial Select Sector SPDR, which has traded since 1998. The historical performance of both indexes indicates that the financial sector generally mirrors the performance of the mainstream indexes like the Dow Jones Industrial Average and the S&P 500.

Although historical performance shows that the financial sector has been slightly more volatile than the overall markets, it has been much less volatile than other sectors such as the technology or energy sectors. But in terms of cyclical analysis, financial funds have moved largely in tangent with the economy as a whole.

Sensible Sector Fund Investing
As with any other sector, investors who seek exposure in financial sector funds should not do so unless they already own a diversified mainstream portfolio. Investors who make financial funds a portion of their portfolios should also be aware that timing specific sectors of the market can be riskier and more difficult than trying to time the market as a whole. Subsector funds are even more volatile by nature than broader-based funds, as their narrower focus will render them more vulnerable to the economic cycles that can affect a specific industry, such as banking or mortgages. Morningstar suggests that investors limit their exposure to any given sector to 5% of their portfolio. The use of such asset allocation strategies as dollar-cost averaging or periodic portfolio rebalancing, either among specific sectors or the overall portfolio is also highly recommended. These methods can effectively reduce the higher level of volatility inherent in sector funds and keep portfolio costs to a minimum.

Costs and Fees
Sector fund investors should closely monitor what they pay in terms of sales charges and annual expenses for sector funds, which, according to Morningstar, typically run higher than funds in more general categories. Morningstar stipulates that sector funds (in any category) tend to cost more than other funds because they often lack the asset base that is found in mainstream funds, such as a flagship growth or income fund. As a result, they do not enjoy the subsequent economy-of-scale pricing that larger funds can offer. Investors who are participating in market-timing strategies would be wise to explore the world of financial SPDRs and ETFs that are available, which provide diversification within the financial sector but trade like stocks and can be purchased much more cheaply than traditional open-end funds.

The Good, the Bad and the Ugly
As with all other types of funds, there are several excellent financial funds available, as well as some losers that should be avoided. A fund family's investment philosophy and portfolio management techniques are provided for investors, with decades worth of information. Finding a suitable financial fund can be done through an investment fund search. You will want to look for investments which having posted a solid long-term performance and compare that performance to other similar funds or to indexes such as the S&P 500. Keep in mind that past performance doesn't predict the future. Also look for financial fund returns after sales charges, which will give more realistic actual returns. Many agencies and mutual fund education websites will rate individual funds, which makes it easier on investors. Using these tools will help pick which investment to make inside the financial sector. (For plenty of information on evaluating a financial fund's performance, check out the Mutual Fund Special Feature.)

Conclusion
Financial sector funds are appropriate for investors seeking exposure within either the financial industry as a whole or a specific subsection thereof. Although the performance of the financial sector tends to follow the mainstream markets, investors should use caution when trying to catch the top or bottom of this sector or any other. Overexposure to any given sector of the market, including the financial sector, can subject investors to undue risk and volatility.

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