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Tickers in this Article: CFC, AET, UNH, NASDAQ:LMVTX
More so than any year in recent memory, success in the stock market during 2008 will be all about proper sector allocation. Despite the healthy bump across the board we've seen in recent days, many large sectors and industries are down 20%, 30% and even 50% over the past 12 months.

On the flip side, plenty of industries have done extremely well - just ask anyone who's been holding a precious metals fund. If your favorite mutual fund has been clobbered in the past few quarters, chances are it had over-allocations (measured against the S&P 500 or other broad index) of sectors like financials, telecom, and leisure.

It's time to do a few quick exercises to see if your fund has been adapting to today's market dynamic and is set up to best profit from whatever 2008 throws our way.

Gather the Most Current Numbers
There are many good resource sites out there for retail investors, including: the fund manager's own website, and aggregators like Yahoo and Google's Finance sites. What we're looking for is a sector breakdown of the funds holdings, along with the most recent turnover figures, and also the top individual holdings. (To learn where to get this information, see Read Your Mutual Fund's Annual Report.)

I generally love to see low turnover ratios at a mutual fund; it signals to me that portfolio managers show conviction in their choices, good due diligence efforts, and are doing their best to keep expenses low.

Any fund that has a turnover ratio less than 50% could be considered stingy in most years, but I would actually rather see that number higher for the past 12 months. That would indicate that the fund is trying to rotate its holdings into sectors with better prospects, or individual companies that have strong and growing international revenues, the latter being a saving grace for many companies over the past year. (For further reading, check out Sector Rotation: The Essentials and Maintaining Your Mutual Fund Equilibrium.)

As a basis for comparison, here's a breakdown of the sector weightings of the S&P 500, as of the end of February:

Consumer Discretionary - 8.7%
Consumer Staples - 10.7%
Energy - 13.6%
Financials - 17.1%
Healthcare - 12.2%
Information Technology - 15.5%
Materials - 3.6%
Telecom - 3.3%
Utilities - 3.5%

Does Your Fund Ever Change?
Some mutual funds have a pre-set philosophy and stick to it religiously. In tune, many investors flock to these funds and appreciate their lack of pizzazz; these investors like to see low annual turnover and consistent performance. The top fund managers in this space tend to have fewer positions, higher weightings, and long time horizons. And on the whole, who can argue with this strategy? All the data tells us that this is the way to consistently outperform the market (if there indeed be one) - low transactional costs, low fees, and a consistent, patient philosophy.

The only problem is that 2008 may not be the year to think that way. We are in the middle of a credit "crisis of faith" to go along with our stagnant GDP. So, even though the stock market loves to be forward thinking and forward looking, it can't happen when the biggest players (I'm talking to you, Bear Stearns) simply don't know how deep the hole they are standing in truly is. The speed at which Bear went from "We're OK" to "Bail us out or we die!" - a weekend - is all the proof I need to surmise that the best minds aren't able to effectively grasp the present and anticipate the future.

Even the Best Have Faltered
Consider the plight of iconic investor Bill Miller, manager of the $16.5 billion Legg Mason Value Trust (LMVTX). Miller had beaten the S&P for over 15 straight years, only to underperform the index by 10 percentage points in 2006 and full dozen points in 2007.

Why the sudden reversal? The combined fears of low growth and frozen credit markets had changed the rules Miller so successfully skated around in the past. Miller had big bets on Countrywide Financial (NYSE:CFC) and healthcare providers UnitedHealth Group (NYSE:UNH) and Aetna (NYSE:AET). Countrywide's troubles are well-known, while health insurers as a whole have dropped 20% in the past year including a nearly 40% drop at UnitedHealth Group.

Miller's instincts to "wait out" the financials and healthcare while cutting exposure to basic materials and energy might have worked in most down markets, but not in this one. In this market, low valuations and even defensive sectors can't outweigh the massive credit fears, and both financials and health insurers are big holders of debt. Miller made his problems worse by having almost zero allocation within energy, which has held up extremely well lately. Sometimes it is just as dangerous to avoid one sector completely as to overweight another.

Parting Thoughts
Some investors will seek out funds that are diving back into fallen areas like banks, housing, and discretionaries. Others would rather see funds mimic the S&P 500 as closely as possible, while simply removing a few of the more dangerous stocks from the broad list. I am willing to give funds a temporary pass on higher turnovers, and may even be attracted to a manager that isn't afraid to accept a few losses to get positioned in the most optimal way going forward.

To find out what those in the know have to say about managing a portfolio and beating the market, see Words From The Wise On Active Management.

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