The whole issue of investing in sector funds sometimes begs more questions than it gives answers. Should you try to pick sectors, or let the managers of diversified funds do it for you?

For most investors, the short answer is—let the manager do it. Most sector funds, particularly the sector indexes, are appropriate only for traders looking to get in and get out, and not for long-term investors.

But there is one exception—which I’ll get to in a moment.

Why am I against sector investing for your long-term portfolio?

First, let's consider returns. Looking back over long periods of time, only half of the ten major stock market sectors (the ones Vanguard’s sector funds follow) have generated market-beating returns: Those sectors are industrials, energy, financials, health care, and technology.

Industrials

Industrial sector stocks, which includes large conglomerates and manufacturers like General Electric (GE) and Boeing (BA), tend to be strongest when the economy is roaring. Yes, this sector has outperformed the broad market, but not by much. And there are plenty of times when it doesn’t outperform. So why make a concentrated bet on it?

Energy

Until a few years ago, energy stocks were severely lagging the stock market. Recently they’ve taken off (see also, "Alternative Energy: Ride the Green Wave!").  But even though oil and gas are two commodities with fairly consistent demand, both supply and prices are anything but stable. That makes investing in this sector incredibly tricky. Many active managers layer energy stocks into their portfolios, but with discretion.

Without a better rationale for owning an energy index, rather than a diversified fund with an energy accent, I’ve got to say there are probably better places for our money, long-term.

Financials

As for financials, I could be smug and just say “Bear Stearns” with an emphasis on “bear" (see also, "Lehman Brothers (LEH) Share Price Smack Down"). But that’s one company, not a sector. However, look what happened in 2007 after the subprime mortgage mess came to light. At the end of 2006, Vanguard’s Financials Index  had returned 19.2% for the year. But at the end of 2007, its one-year return was a negative 17.5%. What else would you expect from Wall Street but to keep their itchiest trigger fingers poised on their own industry’s button? And don't forget that many value funds already have big weightings in financials. Do you want to add more?

That’s the return side. There’s also a risk side, and that’s where tech stock indexes hit reboot. There have just been too many...