The best sector funds

Having languished in obscurity while newer 'megatrends' captured investors' attention, the original breed of sector-specific funds are now turning heads again: energy and financials funds have been among the best performers of 2021 so far. With rate rises moving higher up the agenda as inflation persists, these funds have a good chance of basking in the limelight for a while longer. Polar Capital Global Financials Trust (PCFT), for example, recently set out plans for a share placing on the back of a promising outlook for the portfolio.

There is, of course, a catch. Sector plays can be highly volatile, exposing you to big price movements and the perils of market timing. As we’ve previously noted, Schroder ISF Global Energy (LU0969110765) led the Investment Association Global sector in terms of performance in 2021, but the same fund sat at the very bottom of that performance table for several calendar years prior to that. It's therefore wise to moderate your position size, diversify, and never forget the risks when dealing with sector funds. All the same, the options on offer are worth examining.

Financials

Commonly seen as a beneficiary of rising interest rates, banks and financials in general offer a level of cyclical exposure and provide a contrast to the likes of tech stocks. But the way you express this allocation decision can make a big difference to both performance and the charges you'll pay.

The investment team at AJ Bell, for one, has made use of sector-specific funds, but has also shied away from actively managed strategies in this part of the market. “For much of our sector exposure, we look at the passive route for implementation given the low-cost nature of the products and the fact that many sector-focused funds have patchy records of consistent outperformance,” says the firm’s head of investment research Ryan Hughes.

When it comes to financials, the team recently opted for iShares S&P 500 Financials Sector UCITS ETF (UIFS) which has an ongoing charge of just 0.15 per cent. The fund had an extremely strong 2021, delivering a total return of more than 35 per cent, and this has fed into it having the strongest five-year performance out of a selection of active and passive financials funds at the time of writing.

While the fund’s assets are spread across 67 holdings, it is as a much more concentrated investment than this figure might suggest. As of early February Berkshire Hathaway (US:BRK.A) made up 13.2 per cent of its portfolio, with JPMorgan Chase & Co (US:JPM) making up 10.7 per cent and Bank of America (US:BAC) 7.7 per cent. Beyond its largest allocations the fund has a long tail of small positions, with more than 40 of its holdings making up less than 1 per cent of assets each. The fund nevertheless has a mix of different sub-sector weightings, with diversified and regional banks making up nearly 38 per cent of assets and other exposures including insurance and asset management positions.

Some of the better known active financials funds have had mixed results. To give one example, Jupiter Financial Opportunities (GB00B5LG4657), run by Guy de Blonay since 2011, made a return of nearly 8 per cent in 2021, putting it well behind the global and US financials ETFs that tended to post gains of around 30 per cent or higher. Yet the fund had generated double-digit returns in the prior two years. Importantly, it also fared better than rivals in 2018, a difficult year for equities.

While some may simply want a broad sector exposure, Hughes notes that funds that seem to share the same remit can have notably different allocations. To stick with two active examples, Polar Capital Global Financials Trust had 61.2 per cent of its assets in banks at the end of 2021, with “diversified financials” making up 15 per cent and a 13 per cent allocation to insurance. The fund had much smaller position sizes than iShares S&P 500 Financials Sector UCITS ETF, and 76 different holdings. Some 44.8 per cent of Polar Capital Global Financials Trust was in North America, with 17.5 per cent in Europe and 16.5 per cent in Asia.

Jupiter Financial Opportunities had 60 per cent of its assets in North America and roughly a quarter in Europe. It had 41 per cent in banks, well below Polar Capital Global Financials Trust's position, with a 24.5 per cent allocation to investment banking and brokerage services.

When it comes to banks in particular, it’s worth noting that changes recently proposed by MSCI and S&P Dow Jones indices would see payment processing names such as Visa (US:V) move into the financials sector. This would make many financials ETFs less heavily focused on banks, more diversified and less cyclical. So investors who want a cyclical play may well fare better seeking options in the active space.

Energy and resources

As the fortunes of Schroder ISF Global Energy demonstrate, the energy sector is subject to wild swings in performance. Hughes argues that actively managed energy funds have “a very poor record of predicting the oil price”, leading him to favour another passive option, iShares S&P 500 Energy Sector UCITS ETF (IESU). Like its financials-oriented peer it has hefty allocations to a few stocks, with Exxon Mobil (US:XOM) and Chevron (US:CVX) making up some 43 per cent of its portfolio.

That said, he does favour an active option in the mining space, noting that BlackRock World Mining Trust (BRWM) manager Evy Hambro has a long record of delivering for investors. The trust, which focuses on shares in different miners around the world, has made strong returns in both the short and medium term, although can be volatile when stocks struggle. Stablemate BlackRock Energy and Resources Income Trust (BERI) has a somewhat broader remit, although its share price total returns have been less impressive over the years. Both names recently offered a dividend yield of more than 3 per cent, although there are some concerns that energy dividends could falter in the months ahead.

When it comes to other sectors, the composition of many winning global equity funds of the last decade means investors are likely to already have a good level of tech exposure. Those considering the major tech trusts Allianz Technology Trust (ATT) and Polar Capital Technology (PCT), may wish to bear in mind that the former has tended to be less wedded to a benchmark. As we reported back in 2020, this has tended to give Allianz Technology Trust an edge when it comes to returns.

As with the other sector ETFs, passives focused on tech can come with serious concentration risk, notably when it comes to Apple (US:AAPL) and Microsoft (US:MSFT). The proposals to reclassify payment processing names as financials stocks, taking them out of many tech funds' remit, would exacerbate this problem.

Finally, a more general note of warning. Investors often have significant sector exposures via their other fund holdings. Value funds and certain markets such as the UK and Europe tend to have decent exposure to some of the more cyclical industries, while tech is well represented in growth portfolios and the US. Introducing sector funds to a portfolio can create overlap.