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by Dan Wiener Editor, The Independent Adviser for Vanguard Investors October 27 , 2003

Vanguard, which had winnowed its sector fund family down to just four funds, is going deep into the sector business with 10 new sector index funds based on new Morgan Stanley indexes. The funds should become available later this year.

For now, let's concentrate on the old, tried-and-true sector funds. While Vanguard's existing sector funds family doesn't cover nearly all of the bases its new funds will, the four current sector funds cover several distinct slices of the markets, as their names suggest. Energy, Health Care, Precious Metals and REIT Index invest in some of the largest, and smallest, chunks of the markets. Only REIT Index is limited to our own shores, while the other three have widely varying levels of international holdings, from Precious Metals' 97.1% to Health Care's 26.2%.

My overarching advice when it comes to sector funds is that investors should generally avoid them. They may be good for traders who are willing to move into and out of them rapidly, but long-term investors don't have much business in most sector funds.

Why? Well, one thing you can be sure of when investing in narrowly sliced sectors of the stock market is that, if you wait long enough, just about any dog will have its day, and just about any sector of the market will make it to the top of the performance tables. You only need to look at Precious Metals, which moves dramatically up and down primarily with the price of gold or platinum. While the fund has been outstanding of late, with a gain of 29.3% through September, its long-term record has been unspectacular, and the fund just has not been able to give investors competitive returns. (See chart comparing sector funds.)

However, the one sector fund that I do encourage investors to buy, and have for years, is Health Care (VGHCX). Why do I keep pounding the table for Health Care? One reason is the fund's steady returns. Another is the fact that most of the other sector funds at Vanguard are exactly the opposite—unsteady to the point of frustration. But my top reason has to do with my analysis of the sector and the manager.

With the stock market in bull mode so far this year, Health Care has been running a bit tired, unable to keep pace when stocks are rising. I'm willing to forgive such short-term transgressions given the longer-term success (past) and outlook (future). On an absolute basis, Health Care's 13.3% rise this year is just fantastic. Relative to the 16.9% gain for Total Stock Market or the 52.6% rise for the biotech sector, you might think this punk. I don't.

Why has fund manager Ed Owens of Wellington Management been so successful? Two reasons. First, he runs a diversified portfolio. He doesn't load up on biotech to the exclusion of other sectors, nor does he ignore the HMOs and medical technology companies. If generics are taking share from traditional pharmaceutical companies, Ed will find the best ones and buy them. Yes, this portfolio owns some of everything. Currently he's got just under 40% of assets in drug companies, which he's cut back as his biotech position, 11% of assets, has grown.

Plus, Owens looks for opportunities overseas as well as at home. He currently has about 26.2% of the fund in foreign companies. But diversification would be useless without stellar stock-picking, and that's the manager's other secret weapon. Hence, his outperformance and great long-term returns.

Still, many investors, including many who think indexing is the only way to invest, see this fund as a dangerous addition to a “diversified ” portfolio because it invests in “just ” one sector of our economy.

The naysayers have blinders on. You and I don 't. So we'll just keep making money here, over time, with low risk and high returns. Consider the fact that, though this is a sector fund, its relative volatility is lower than the stock market's, and has been for years. Owens' ability to navigate through an industry that represents more than 15% of GDP makes this one of the best mutual funds available—period. Plus, while Wall Street tries to rekindle its affair with tech stocks, prices on some high-yielding, profitable drug stocks have gone wanting. Don't think Owens hasn't noticed.

Investing in the health care industry is one of the smartest moves you can make if you're interested in long-term growth. Vanguard's Health Care fund should be a part of most anyone's portfolio and is particularly appealing for young investors, including children. My family owns a ton of this fund. My private money-management clients do as well.

Remember, Health Care sports a $25,000 minimum, but it's worth it. Ed Owens is ambivalent at best about the Fund's enormous girth. If you're not already a shareholder, don't delay, because as Vanguard has closed the fund in the past, they could easily do it again, without notice.

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