If you think a particular sector of the economy is about to take off you might want to consider sector-focused investments, but it’s important to be aware of the greater risks involved.

The attraction of investing in specific sectors is it enables you to avoid parts of the economy which are performing badly and concentrate on the parts that are doing well. This could, in theory, lead to better overall returns.

Over the last 10 years, the technology and consumer goods sectors have significantly outperformed whereas the financial and mining sectors have struggled. If you succeeded in building a portfolio reflecting these trends you’d be sitting in a very strong position today.

It can be very difficult to predict how sectors will perform, as evidenced by the surprise dotcom crash back in the early noughties. This year, the mining, oil and gas sectors have bounced back due to a recovery in commodity prices.

Time and effort

Investing in sectors takes a lot of time and effort because you need to keep track of both economic news and company announcements. Ryan Hughes, head of fund selection at AJ Bell, says company announcements enable you to take a temperature check of a specific industry and are often a good guide for when a certain sector is picking up or potentially slowing down.

‘Importantly, investors should take their time to read and digest company statements as hidden in the words of the chairman and chief executive are often little clues as to their thinking on the health of not only their business but the wider sector and economy that they operate within,’ he says.

Unless you have a particular view on an individual stock, it’s generally better to opt for a diversified vehicle such as a fund, investment trust or exchange-traded fund (ETF). Gavin Counsell, senior multi-asset fund manager at Aviva, says there is nothing worse than getting the right investment thesis, only to have the return profile dominated by an individual company-related issue.

A good example of this is BP (BP.). As one of the largest oil producers, many people have used BP to invest in the energy sector, but its performance has been rocked by the Deepwater Horizon oil spill in April 2010.

Funds vs ETFs

A fund or an ETF lets you invest your money across several companies, spreading the risk.

There are specialist funds and ETFs covering a wide range of sectors, from mainstream ones like financials and mining through to niche ones like water, timber and clean energy.

ETFs are good at getting broad exposure for a low cost, whereas funds offer access to an active manager who has the specific skills to hopefully outperform the market. Funds tend to be more expensive and there is always the chance that the manager will stray from the theme.

Sector-focused funds and ETFs are riskier than broader investments because companies often move together and are impacted by the same factors. Adam Laird, head of ETF strategy, Northern Europe at ETF provider Lyxor, says the whole energy sector dropped when oil prices crashed, resulting in an 18.4% decline in the MSCI World Energy index in 2015.

Sector dynamics

Before investing in any sector you need to understand its dynamics. Counsell at Aviva says a good starting point is to look at the sector’s valuation – for example the price to earnings ratio and dividend yield.

‘Then there will be sector-specific information you need to take into account – for example energy stocks will be impacted by oil prices, potential announcements by (oil producers’ cartel) OPEC, expected global trade and so on. Such factors will be less important if you were investing in, say, healthcare,’ says Counsell.

In general, sectors such as tobacco and pharmaceuticals typically perform well in bear markets. Mining and oil and gas are inherently more volatile, while other sectors are more defensive and exhibit less volatility, such as consumer goods and services. Some sectors have fewer stocks so will be less diversified.

Counsell says another risk that has developed recently is the demand for income, which has pushed up the price of sectors compared to historic levels. ‘These are sectors such as utilities that are often viewed as bond-proxies – i.e. lower risk with stable dividends more correlated to bond yields. If yields were to rise dramatically, these sectors would be more significantly affected. We have started to see the volatility of sectors like utilities increase over last 12 to 18 months,’ he warns.

Portfolio allocation

Given the greater risks, it’s advisable to keep your investment in any individual sector to less than 10% of your overall portfolio. You might also want to consider blending a few sectors to spread the risk.

Hughes at AJ Bell suggests using sector investing as a way of tilting exposures within your portfolio, rather than using it as a core element.

‘This can be a useful method of increasing or decreasing the risk as you see fit, without becoming wholly reliant on one or two sectors to drive performance,’ he explains.

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