The Performance, Risk, and Diversification of Sector Funds

Sector funds' self-imposed limits on diversification have both costs and benefits. Sector funds tend to perform as well as other equity funds, but their performance tends to be sensitive to the benchmark that is used. In addition, sector-fund managers do not exhibit any significant persistence in performance. Although sector funds tend to be moderately less diversified than other equity funds, they do not entail greater systematic risk. Sector funds exhibit larger total risk than the control sample, but they are not any riskier than small-cap and aggressive-growth funds. Factor analysis results provide evidence that variation in sector-fund returns can be attributed to two common underlying factors, and the primary factor appears to be the return on the market index.