I was surfing the web and came across Jason Zweig's personal website, which has a wealth of interesting articles and insights. Zweig, a finance columnist for The Wall Street Journal, former senior writer for Money magazine, and the editor who added extensive commentary following each chapter in the 2003 revised version of Benjamin Graham's The Intelligent Investor, is definitely one of the "good guys" in the finance and personal investing world. He subscribes to the low-cost indexing approach that is far too uncommon among financial commentators these days.
In any event, I came across his article "Get Smart About Sectors," published in December 2002 in Money. At first glance, this seems like a very un-Zweig-like article. Sector investing? Doesn't that increase risk and reduce diversification? Well, yeah, if you're simply investing in a sector because you think it's "hot" and your motivation is simply to optimize returns. Rather, Zweig's article proposes another motivating factor behind sector investing - to serve as a hedge against human capital. That is, your job. Particularly if you work in a high-risk industry, you may want to think about balancing that risk with your financial capital in a sector that correlates the least with your human capital. This is the basic tenet behind diversification; and Zweig argues that this strategy will help reduce risk and increase diversification.
I have heard of this strategy in passing, but hadn't come across a detailed article such as Zweig's until now (despite the fact that it was published in 2002!). This premise certainly makes sense. Just ask those at Enron who loaded up on company stock (as a sidenote, I recommend keeping your company's stock holding as less than 5% of your net worth if at all possible). On page 2, you can consult a chart of the various sectors and which sector correlates the least with it. For example, if you work in mining, you might consider having a position in a utilities sector fund since it has the lowest correlation at -17. Zweig does not encourage moving into and out of sectors in an attempt to time the market's movements. Rather, he encourages a buy-and-hold long-term approach just as he does with typical index funds.
Zweig comments that the average sector fund charges 1.74%. That "average" is an absurd fee and can be easily avoided. Perhaps they didn't exist at the time of the article, but you can gain access to any of these sectors through Select Sector SPDRs. They have an expense ratio of about 0.22% - a far cry from the 1.74% average. Another alternative if you don't want to go to the ETF route, is to use the Fidelity Select Funds, which are actively managed and charge about 1.0%, but only have a $2,500 minimum. (You must hold these for 30-days or will be charged a redemption fee.) Vanguard also has several sector specific funds and ETFs that are in the 0.25%-0.38% range, but some require a minimum investment of $25,000 and charge a redemption fee of 1% if held for less than one year. But, again, you're planning to hold it more than one year anyways, right? Consult each individual prospectus or fund page for details. Some are actively managed, while others are simply indexes. For example, here is one of the Energy funds.
Just remember, it is not advisable to attempt to use sector investing as a means to outperform the market and move into and out of hot sectors every two months. (Although I did explore a sector rotation investing strategy in a post here. The conclusion basically was that any outperformance one experiences due to sector rotation can be attributed to higher risk and volatility. While during certain periods this strategy did outperform, there were other periods of significant underperformance. Volatility overall was much greater than simply holding the total market.)
In the end, the idea that sector funds can be used as a hedge against potential job loss and serve to further diversify your portfolio is an interesting one. I don't think this strategy is imperative for everybody to use by any means, but if you're in a particularly high-risk industry or have concerns about job security or pay raises, this strategy might be one to consider.
Update: There is a timely article that's worth a read about the importance of human capital and its relevance to risk-taking in one's investments in today's Wall Street Journal. The article, "How to Think Smarter About Risk," is written by Mosche Milevsky, an Associate Professor of Fianance at York University in Canada. While he doesn't talk about sector investing, he introduces the concept of "personal beta," advising individuals to consider how a drop in the stock market would affect their paycheck and how such risks should be considered when devising a portfolio. If you're an investment banker your earnings are more tied to the stock market and you may want to take fewer risks with the rest of your portfolio. On the other hand, if you're a nurse or tenured professor such market movements have little relevance and you may want to be more aggressive and in stocks with your financial capital. Interesting read!
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