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Are Sector Hoppers Worth Jumping Into?

By Eric Walhlgren Just two years ago, telecom-equipment maker Lucent Technologies (LU) was the most widely held U.S. equity and traded at over $60. With the shares now at less than $4, it's no surprise that much of the stock-buying public has lost faith in buy-and-hold investing. Indeed, many investors are starting to wonder whether putting money in stocks now makes any sense, since the broader market is down more than 8% year-to-date, and it seems more difficult than ever to read the tea leaves.

Enter a relatively new crop of mutual funds that seeks those elusive gains by buying stocks only in the best-performing market sectors at any given time and then selling them off as other sectors offer higher returns. Managers of these so-called sector-rotation funds say the model enables them to generate above-average returns because they only stick with the winners and ditch sectors before they start to drag down a portfolio.

Rydex Funds, which already runs several sector funds, is the latest to get into rotation. The Rockville (Md.) company says its Rydex Sector Rotation Fund (RYSRX), which opened on Mar. 22 with about $14 million in assets, was the answer for investors wondering about what sector to invest in and when. Since its launch, the fund has grown to about $100 million. So far, it has posted a negative return of about 1.9%, which isn't too shabby considering that the Standard & Poor's 500-stock index has fallen 8.6% in the same period.

"RIDE THE TREND." Basically, every month Rydex identifies the top quintile of industries -- or roughly the top 12 -- in terms of price appreciation over the previous 12 months from among the 59 industries making up the Standard & Poor's 1,500-stock index, says Chuck Tennes, the company's director of portfolio. Rydex in turn invests in stocks in these top industries, rotating into different sectors every month as the top quintile changes depending on performance. If an industry is still in the top quintile once the month is over, Rydex keeps it in the portfolio until it falls down the list.

"We know that when a stock or group of stocks finds a trend, it tends to go on for weeks or months or even for years," says Tennes. "If a sector is well performing or poor performing, that stays for a while. [Our model] captures a trend early enough when you can still ride the trend."

The fund has a built-in sell discipline, Tennes adds, so that out-of-favor industries get dumped from the holdings at the monthly review, sparing investors from the frustration of being stuck with bum stocks in their portfolio. Among the industries in Tennes' portfolio right now are health-care providers, household durables, food and beverage names, restaurants and leisure companies, and building-materials, which are all stocks being helped by the fact that the U.S. consumer continues to spend despite a shaky recovery.

SECOND TIME ROUND. Some mutual-fund experts say sector-rotation funds could make sense, as the broader market isn't expected to make headway any time soon. "What we're going to see over the next few years is most likely a trading range," says Rosanne Pane, mutual-fund strategist with Standard & Poor's. "Anyone who has a fund where you can rotate into the [better- performing] sectors could be at an advantage."

With only a handful of such funds in existence, however, Pane says she's cautious about predicting their future performance. "We can't judge how sector rotation will do when you really have such a small sample," she says.

Sector rotation isn't a new concept, points out Russell Kimmell, director of fund analysis at fund-rating service Morningstar. Mutual-fund companies first gave it a try in the 1980s and early 1990s. But because timing the market in a bull period is actually harder than picking stocks, "they generally ended so badly that most of them got liquidated," he says. With the market going sideways at best now, sector-rotation funds might have a better shot this time around, some fund managers argue.

The managers behind the new generation of sector-rotation funds, which first began appearing about five years ago, say they're responding to the investing public's growing dissatisfaction with results from buying and holding stocks. Although investors liked the idea of always being in the best-performing sectors, they wanted someone else to do the trading for them, the managers say. Keener strategies will help the new funds avoid the pitfalls of the past, they add.

DIFFERENT MODELS. One of the better-performing sector-rotation funds is the $69 million ICON Fund (ICNIX), opened in October, 2000, by Meridian Investment Management in Greenwood Village, Colo. The fund is up 0.25% year-to-date. It posted a 5.1% return in 2001, while the S&P 500 lost 13.04%.

Although the rotation idea is the same, ICON's methodology is a little different than Rydex' price-appreciation model. ICON fund managers determine the potential of each industry in the S&P 1,500 by calculating the intrinsic value of each company in the sector and comparing it to the market price of each. Industries are considered bargains if companies within them are trading below their intrinsic value and expensive if they're trading above it.

The ICON Fund buys stocks in the top industries based on value and price performance relative to the market. "If they become expensive, we rotate out of them and go back into what has emerged as a bargain," says Bob Straus, assistant portfolio manager. "But we don't equal weight each stock in the industries we pick. We drill down to the company level, and we look for our favorite companies in those industries."

BIG DROPS. The ICON Fund is now in seven sectors, including consumer-discretionary stocks, industrials, and financial services. Sector-rotation fund managers advise investors to keep their funds in tax-sheltered accounts such as 401(k)s. Because these funds buy and sell stocks more frequently than other funds, investors are liable to be stuck with more capital-gains taxes.

Not all sector-rotation funds have had steady results. The $17 million T.O. Richardson Sector Rotation Fund (TRSRX), which opened in December, 1998, returned 65.8% in 1999 -- outperforming the S&P 500's 21.04% return by a wide margin. But after losing 7.5% in 2000, the fund declined 30.8% in 2001 -- a far bigger drop than the S&P 500's fall of more than 13%.

Austine Crowe, the fund's Atlanta-based portfolio manager, says he has made changes to his model to correct the problems that led to last year's losses. Among the changes: When stocks aren't outperforming money-market funds, some assets will shift to the money market to assure more stable returns. He adds that Morningstar puts his fund in the top quintile for three-year annualized returns. The fund is off 6.46% so far this year-to-date.

SECTOR SKEPTICS. Another fund, the $77 million MFS Managed Sectors Fund (MMNSX), has also had mixed results. It posted gains of 84.6% in 1999 and losses of 21.5% and 35.7% in 2000 and 2001, respectively. The fund is off 10.51% year to date.

Such mixed results are part of the reason some mutual-funds experts are skeptical of sector rotation. Morningstar's Kimmell says he believes investors are better off looking for funds with managers who are good at picking stocks rather than for what he calls "sector-hopper" funds that try to identify the hot industries of the moment. "It's hard to beat the market," says Kimmell. "A lot of people have done it through issue selection, but very few have been able to do it consistently through sector rotation."

Sector-rotation fund managers, meanwhile, argue their method is solid. Even though they're picking industries rather than stocks, they say the stocks in the industries they select undergo the same scrutiny as they would in a more typical mutual fund. "We believe you have a higher probability of being right on an industry than on being right on one stock," says ICON's Straus. "There's a tremendous amount of risk on being right on one stock."

With the few sector-rotation funds having only short track records, it may take a while to figure out whether Straus is proven right. But with market watchers expecting little from the overall market this year, funds that manage to find pockets of gains could be worth checking out. Wahlgren covers the markets for BusinessWeek Online in New York

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