Morningstar - Q1 2021 - 10

Dispatches

A Healthy Case for
Sector Funds The right
investment can
help investors meet
long-term goals.
PHILLIPS CURVE

Don Phillips
In the midst of a pandemic, healthcare
naturally becomes a central topic, but for financial
planners, healthcare is always at the core
of their thinking. As their clients age, rising health
costs and longer life spans become two of the
most crucial issues for a successful financial plan.
I can't recall a single financial planning
conference where the topics of longevity and
rising healthcare costs didn't take center
stage. The growing sophistication of treatments
and the corresponding costs prompt advisors
to extend the horizons of their clients' portfolios
and tilt them more heavily toward equities
to meet this steep challenge.
I've heard many great insights from advisors
into how they prepare their clients for the
challenge of longer lives and higher healthcare
costs, but there's one conversation that
stands out. It was at the Institute of Certified
Financial Planners retreat at Yale University in the
early 1990s. The conversation centered
on the then-conventional practice of putting 5%
to 10% of a client's portfolio in gold funds.
The idea, forged in the inflationary 1970s, was that
this would protect the client's purchasing
power as prices rose. It was a reasonable practice
in theory, but in practice, many advisors found
it difficult to implement. To make the strategy work,
one had to sell off gold shares in years when
they rose and step up and purchase more in years
when they fell. The problem was that given
gold's volatility, the shares often spiked or crashed
and were therefore either the client's favorite
or most despised part of the portfolio-and

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Morningstar Q1 2021

advisors had the difficult task of getting their
clients to either sell what they most loved or buy
what they most hated.
One advisor took exception to this strategy.
She argued that her clients already had a certain
level of inflation protection in their portfolios, as
she routinely shifted clients to higher equity
exposures than they had before working with her.
She further argued that her clients weren't
worried about general inflation like the rising price
of cotton or copper. What her clients were
concerned about was outliving their wealth and
facing growing healthcare costs as they aged.
This advisor's solution was to ditch the gold
funds and instead allocate 10% of clients' assets
to Vanguard Health Care VGHAX. She thought
that the fund was likely to grow faster than the
rest of her clients' equity positions and that
rebalancing would be easier than with the volatile
gold funds, as the healthcare fund was apt
to have an upward growth trajectory and suffer
fewer sharp losses. Moreover, she noted that
because her aging clients' equity portfolios tended
to skew toward income-producing value
funds that were overweight in utilities, REITs, and
energy stocks, her clients had diminishing
positions in healthcare stocks as they aged, even
though their vulnerability to rising healthcare
costs increased. Her reasoning seemed sound to
me, and the results have proved the merits
of her approach. I suspect that her clients have
been very pleased.
I was thinking about this long-ago conversation
recently in the context of some internal portfolio
construction conversations at Morningstar.
Generally, Morningstar's fund analysts frown on
sector funds. Too often, we see money pour into
them at peaks and gush out during troughs.
When we first looked at dollar-weighted investor
returns, we found that sector funds as a group had
the largest gap between the amount of money
investors actually made and what they would have
made had they simply bought and held the
shares. Simply put, sector funds in general tempt
investors to do the wrong thing at the wrong
time. But the story above illustrates that
sector funds can, in the right circumstances, play
an effective long-term role in a portfolio.

I think this advisor's plan works for three
main reasons. First, it has a specific purpose that
matches a client need with the investment
area. It's easy to recall why you have this
investment in the portfolio and, hence, to have the
courage to buy more in times that the fund
falls from favor. Second, the plan has a disciplined,
long-term implementation strategy. The client
has an advisor to encourage rebalancing, and the
rebalancing happens on a predetermined
annual cycle. When healthcare stocks overheat,
the client sells; when they fall, the client
buys more. Third, the advisor chose a low-cost,
high-quality fund rather than buying individual
stocks or a more narrowly defined thematic
fund. Vanguard's healthcare offering has long
been one of the better-diversified and lowercost funds of its type.
I don't think I'll win over all of our analysts
to the side of sector fund investing, but for me, this
advisor's rational, forward-looking deployment
of a sector fund showcases how advisors can
intelligently match investment to investor, to invest
with a specific purpose and meet specific
goals. It's the kind of creative planning that
engages clients without abandoning the discipline
of contrarian thinking (through rebalancing),
diversification (by not using individual stocks), and
keeping costs down. It's not the theoretical
perfection of buying and holding the entire market
forever, but it's something that resonates
with real-world investors. To me, it's a healthy
approach to portfolio construction. After all,
even Jack Bogle launched a few sector funds in
his day. K
Don Phillips is a managing director with Morningstar
Research Services LLC. He is a member of the editorial
board of Morningstar magazine.
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