Six Tips for Sector Fund Investing

Many investors like to be invested in the leading sector and specialty funds and exchange-traded funds, but the hair-raising volatility of these funds can make it difficult for investors to stick with their investment strategy.  Although the goal of all equity investors is to sell their investments for more than they paid for them, many investors end up selling their funds or exchange traded funds (ETFs) when they start to drop, only to buy back after they’ve rallied.
We’ve learned that if we are going to invest in more aggressive funds, we have to be disciplined. Here are some of the guidelines that help us stick to our strategy:

1. Set Aside a Portion of Your Portfolio
We suggest carving out just a portion of your portfolio for more aggressive funds. This part of your portfolio should aim to maximize returns and it should be a component where you can tolerate greater volatility.
In our moderate growth portfolios, like the FundX Upgrader Fund (FUNDX), we limit speculative funds to 30% and of that allocation we generally limit 10% to the most concentrated sector funds and ETFs.
Particularly aggressive investors may venture more of their portfolio to these speculative funds. The FundX Aggressive Upgrader Fund (HOTFX) invests 60% in speculative funds and ETFs, while the ETF Aggressive Upgrader Fund (UNBOX) may be entirely invested in sector and specialty ETFs.

2. Diversify Your Exposure
Sector and specialty funds and ETFs can be volatile so take smaller positions in these funds. Instead of concentrating your exposure in a single sector, take small positions in a number of funds from several highly ranked sectors. Rather than buying a fund that tracks one developing economy, we may opt to buy a fund or ETF that invests in several emerging market countries or regions.
In the FundX Upgrader Fund (FUNDX), for example, 30% of the portfolio is invested in speculative funds but we don’t just buy one or two sector funds. As of June 30, 2011, FUNDX held 15 different sector and specialty funds including funds focused on energy, biotech and small- and mid-cap growth.

3. Don’t be Afraid to Take Losses
or Leave Potential Gains on the Table
It’s difficult to sell funds that have posted losses, and it’s often just as difficult to sell funds that made good gains.  But don’t hold on to funds that have performed badly in the hopes that they will come back. When managing the FundX Upgrader Funds, we replace funds and ETFs when our performance-based ranking system indicates that there could be a better place for us to put our money.
In the FundX Aggressive Upgrader Fund (HOTFX), for example, we sold semiconductors and natural resources funds last quarter in favor of biotech and growth.

4. Expect Volatility and Stick to Your Discipline
Large moves are a normal part of investing in stock funds and ETFs, but the normal volatility of aggressive funds and ETFs can make it difficult to stay the course–even for experienced investors.
When speculative funds are in favor, outsized gains tend to tempt investors to increase their allocation to the hottest sectors and specialty funds, but these funds may fall more than 10% in a matter of weeks.  Because these funds are so volatile, we chose to limit the size of our positions. It’s not unusual for us to take 1% to 2% positions in a number of sectors.

5. Fight the Urge to “Double Down” or Go “All In”
It can be tempting to jump into the most speculative sectors when they are hot. It can also be tempting to double down when positions fall hoping they pop back up. But try to resist these casino-like techniques.  We suggest that you adjust your allocation to aggressive funds based on your risk tolerance, not based on how well or how poorly a position is doing.
Among more aggressive funds, we may occasionally skip over a fund that’s had a massive gain just before our buy signal, or we may opt to take a smaller position. But once we have established a full position, we will not exceed that position size.

6. Revisit Your Allocation Over Time
Being disciplined does not mean that you don’t revisit your decisions as your circumstances change. As you accumulate wealth, it makes sense to revisit your allocation between equities and fixed-income and rebalance to meet your current circumstances.

• Small- and medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies.
• Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods.
• Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities.
• Non-Diversification Risk –The Underlying Funds may invest in a limited number of issuers and therefore may be considered non-diversified.
• Short Sales Risk –The Underlying Funds may engage in short sales, which could result in such a fund’s investment performance suffering if it is required to close out a short position earlier than it had intended.
• ETF Trading Risk – Because the funds invest in ETFs, they are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value ("NAV"), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a Fund’s ability to sell its shares.