Sector Funds -- Third Quarter 2002 Review

Oct. 9, 2002 — It looks like most sector fund bets, with the exception of gold and real estate, have gone bad this year.

In the third quarter alone, one of the worst on record in recent history, sector funds lost almost 17.2% on average. They have shed 27.2% since as of the start of the year, without much immediate relief in sight for the categories hardest hit.

Though every sector fund category was negative across the board in the third quarter, tech took the brunt again, with the average tech fund plunging 26%, versus a loss of 17.3% for the S&P 500-stock index. The ax also fell on natural resources funds, down 16.3% for the quarter, and funds investing in financials, which lost 15.4% on average. Utility funds fared even worse, down 17.7%.

Gold and precious metals funds pulled back too, falling 4.2% during the third quarter, but are still on pace to beat the market and most domestic equity funds for the third straight year. Gold funds have gained 46.8% on average since the start of the year, despite the volatility in the sector. The average U.S. domestic equity fund, in contrast, has shed 27.3%.

“Gold is basically constant, the volatility is around it,” notes Frank Holmes, chief investment officer of US Global Investors. The two funds he runs — US Global Investors Fds:World Prec Minerals (UNWPX) and US Global Investors Fds:Gold Shares (USERX), have both been strong performers, up 58.4% and 60.0%, respectively.

Though global pessimism, fear of war, and weak profits are to blame for the current malaise surrounding most sector fund performance, gold and precious metals fund managers are still bullish on their sector, believing that the gold shares they own are poised to go higher. They cite improving fundamentals in the industry, falling mine production and supply, the threat of war, and the deflation of the market bubble, which has led to questions of creditworthiness.

The top-performing precious metals fund, First Eagle SoGen Gold Fund (SGGDX), has risen 80.5% since the start of the year, focusing primarily on shares of gold producers unhedged to the rising price of gold.

“We think we are in an early bull market,” comments Jean Marie Eveillard, the fund’s manager. “From the bottom at $250 an ounce, the price of gold has moved about 30% to $325,” he notes. “To my mind, that is not a big move. I think the only thing that can derail what appears to be a bull market in gold would be a return to prosperity throughout the world.”

The only other sector fund category to report gains so far this year has been real estate. Funds invested in the sector have risen 3.1% since the end of the third quarter, aided by dividend-paying REITs, which have been more defensive with their steady income streams.

While some of the top funds in the sector had been fueled by capital appreciation in home building stocks earlier in the year, the income cushion REITs afford came back into vogue in the third quarter, making a total return approach advantageous. The top performer, Alpine Realty Income & Growth Fund/Y (AIGYX), has risen 13.4% this year. Runners up included Brazos Real Estate Securities Portfolio/Y (BJRSX), up 11.1%, and Phoenix-Duff & Phelps:Real Estate Sec/A (PHRAX), up 9.9%.

Though funds invested in health care and biotech are down for the quarter and year to date, managers are bullish going forward.

“In mid to late July we introduced biotechnology again and we have not had them in there for about a year and a half,” notes Craig Callahan, chiefinvestment officer of Meridian Asset Management and manager of ICON Healthcare (ICHCX), the top performer in the sector year to date. “We started buying drug stocks again in early August,” he added, after they became “back on sale.” Health care is a favorite sector for Callahan goingforward.

Greg Aurand, manager of Orbitex Health & Biotechnology/A (ORHAX) sees a biotech rebound in the fourth quarter perhaps not unlike last year’s. He points to more peer conferences in the industry, which usually kick off in the fourth quarter, and low valuations on stocks in the sector, as well as in some health care and managed care issues.

“The medical data tends to be a lot stronger this time of year,” says Aurand, noting that there have been relative positive responses from the FDA of late. He thinks we may be moving back to a “more moderate approach to drug approval and review.” Aurand also thinks a lot of the small-cap biotechs have already reached their lows, and has a positive outlook on selected shares in the industry. His fund is currently 45% in biotech.

Tech funds continued to falter badly in the third quarter, losing 26%. Year to date as of the end of the third quarter the average tech fund plunged 50.5%. With the slowdown approaching the end of a two year period, managers say stock picking will be key within tech’s subsectors. Funds that managed to skirt the carnage in the sector have done just that, and, in some cases, have held large cash positions to boot.

Huntington Fds:New Economy Fund/Inv A (HNEAX), the top performer with a loss of 14.6% through September 30, was launched March 1 last year after the implosion in the sector had already occurred. “It wasn’t news to us that it was likely to continue for some time,” says manager Bernard Shinkel.

The portfolio, concentrated broadly on growth and technology in the “new economy,” has focused considerably on tech “implementers” during the downturn. These are companies that enable technology in products and processes, rather than develop innovations, Shinkel explains. He points to his holding in Lear Corp (LEA) as an example. The manager also holds stocks of companies in a second group he calls “new age technology,” that is, small- to medium-sized rapid growth businesses that are creating new processes and products. Examples include Expedia Inc (EXPE) and Fair Isaac & Co (FIC), a credit scoring company.

Generally, however, tech fund managers don’t see much of an immediate improvement on the horizon.

“We’re not going to come in and all of a sudden have a bull market in technology again — obviously, there was a lot of overcapacity and a lot of damage done,” comments Robert Dean, co-manager on Franklin Custodian Fds:DynaTech Series/A (FKDNX). His fund, which is currently 40% in cash, fell 24.6 for the year, or half as much as the average tech fund, making it the second best performer year to date as of September 30. However, Dean’s outlook is not completely dour. He believes that technology is going to grow faster than GDP over the next 10 to 15 years. “We don’t think technology is dead for sure.”

SECTOR FUNDS