By: John Ruppel
One main attraction to index investing is that you know that your portfolio performance will not be much worse than the major averages. Of course a disadvantage to index investing is that you know you will not beat the averages either.
Most papers and financial magazines have a the year end ranking of mutual funds and ETFs, and you will find that almost always some narrow sector fund like energy or tech stocks leads the gains for the year.
With that as background, let's review the relative success of sector and country funds over the last several years. We will look at the Fidelity mutual fund family, primarily because they have a large offering of funds (over 100 equity funds alone, including domestic sectors and international funds, including country funds) and these funds have a longer trading history than many of the ETFs that can be used today for sector trading.
We can see that even for 2002 (a bear market by any definition), we saw the overall market down by better than 20%, yet there were three Fidelity funds that had a positive return for the year. And of course for the stronger market years like 2003 and 2004, there were many funds that had much bigger gains than the overall market.
Looking at the numbers, from 1999 through 2005, the three best performing Fidelity mutual funds each outperformed the broad market by at least 30 percent each year. Of course, the worst performing funds underperformed the overall market by at least 10 percent each year as well. So sector trading can be a double edged sword as well.
These numbers demonstrate the great profit potential from sector trading, but also highlight the risks associated with trading without a system to get you into the strong sector funds at the right time while getting you out before it's too late. Some type of disciplined approach is clearly needed.
Previously we described a simple trading system that uses Fidelity Select funds for a sector trading system. This system, which trades once a month, had historically returned over 16% a year. This demonstrates that a simple sector trading system that anyone can trade can yield results better than the overall market.
But with this simple one fund system you may have above market risk. For example, this simple system had almost a 50% drawdown in the 2000-2002 bear market. But there are simple changes that can be made to build a trading system that keeps above market returns while significantly reducing the risk of sector trading.
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