mutual funds workshop health and technology: high-powered

AAII Journal/November 1998 3

MUTUAL FUNDS WORKSHOP

As the stock market gives up ground, which it inevitably will do from timeto time, investors often think about what they missed in the last run-up andhow to position their portfolios for the equally inevitable next run-up. Just asinvestors might increase their cash positions in anticipation of a marketdecline or move from more aggressive stock holdings to less volatile stocks, inanticipation of the next great market surge investor’s thoughts often turn tothe stocks and sectors with the greatest promise.

What might first come to mind? Health and technology—health because ofthe aging population, gene research, new pharmaceuticals and drugs, and thepromise of biotech in general; technology because, whatever technology is, itis synonymous with growth.

Given the complexities of firms in these areas, sector funds in health andtechnology provide both specialized management and necessary diversificationfor investors interested in these sectors. It is often suggested, for example,when investing in biotech stocks that investing in one biotech stock is poten-tially disastrous, while a portfolio of biotech stocks is simply high risk. Fewinvestors have the depth of knowledge or the experience in the health sciencesto assemble a portfolio of 10 to 15 individual stocks in biotech, drugs andpharmaceuticals, and medical services and equipment. And the same is truefor technology.

While building a mutual fund portfolio made up solely of a few volatilesector funds is far from optimal for just about any individual investor, addinga few sector funds to an already diversified portfolio to boost the portfolioweightings in industries with exceptional long-term growth potential is areasonable approach for many. The difficulty for investors beyond the deci-sion on the degree of portfolio commitment to any sector is deciphering justwhat specific sectors are in a health sector fund or a technology sector fund.

Table 1 lists the no-load and low-load sector funds reported in The Indi-vidual Investor’s Guide to Low-Load Mutual Funds and the Quarterly Low-Load Mutual Fund Update that are health and technology related.

While the health sector funds run the gamut from biotechnology to medicalservices delivery, they all arguably fall within the health classification. Whereto draw the line on technology sector funds, however, is problematic. Aretelecommunication firms providers of technology, enhancers of technology orusers of technology? MCI and Worldcom, for instance, are in the telecommu-nication services industry, which is high tech, of course, but are they technol-ogy stocks? Probably not, but close. Two telecommunications sector funds,Fidelity Select Developing Communications and Fidelity Select Telecommuni-cations are included under technology in Table 1 for comparison, but reason-able arguments can be made that they are not truly technology funds. Inves-tors must make the final cut after reviewing their existing portfolio to deter-mine how any sector fund might create overlaps with existing holdings or failto fill in portfolio sector gaps.

HEALTH

First, a look at the health sector funds. Listed are the top three sectors for

By John Markese

Given thecomplexities ofcompanies in thehealth andtechnology fields,funds focusing onthese sectors providespecializedmanagement anddiversification forinvestors interestedin commitments inthese areas.

John Markese is president of AAII. The article was researched by Jean Henrich.

HEALTH AND TECHNOLOGY:HIGH-POWERED SECTOR FUNDS

4 AAII Journal/November 1998


TABLE 1. HEALTH AND TECHNOLOGY SECTOR FUNDS

Health Sector Funds (Ticker)Health Sector Funds (Ticker)Health Sector Funds (Ticker)Health Sector Funds (Ticker)Health Sector Funds (Ticker) Top 3 Sectors (Percentage of Portfolio)Top 3 Sectors (Percentage of Portfolio)Top 3 Sectors (Percentage of Portfolio)Top 3 Sectors (Percentage of Portfolio)Top 3 Sectors (Percentage of Portfolio) Top 5 Stocks (PercentagTop 5 Stocks (PercentagTop 5 Stocks (PercentagTop 5 Stocks (PercentagTop 5 Stocks (Percentag

Fidelity Select Biotechnology (FBIOX) biotech 43%, drugs 17%, pharmac’l preparations 7% Genentech 10.4%, Chiron 6.

Merck 5.7%, Schering-Ploug

T. Rowe Price Health Sciences (PRHSX) pharmac’ls 25%, biotech 21%, hospital supply & med devices 16% Collagen 3.7%, IDX Systems

Warner-Lambert 2.7%, Nati

INVESCO Strategic Health Sciences (FHLSX) drugs 57%, medical equip 18%, biotech 5% Merck 7.2%, Bristol-Myers S

Schering-Plough 5.6%, Ame

Vanguard Specialized Health Care (VGHCX) drugs & pharmac’ls 51%, international 21%, Warner-Lambert 5.9%, Pfizer

medical & dental instruments & supplies 8.5% Bristol-Myers Squibb 4.8%,

Fidelity Select Health Care (FSPHX) drugs 42%, medical supplies & appliances 12%, hospitals 4% American Home Products 7.

Merck 5.9%, Bristol-Myers

Fidelity Select Medical Delivery (FSHCX) hospitals 35%, HMOs & outpatient care 24%, medical servs 6% United HealthCare 8.2%, He

HEALTHSOUTH 6.9%, Colu

Technology Sector Funds (Ticker)Technology Sector Funds (Ticker)Technology Sector Funds (Ticker)Technology Sector Funds (Ticker)Technology Sector Funds (Ticker)

Fidelity Select Electronics (FSELX) semiconductors 29%, computers 23%, software & servs 13% Gateway 2000 6.0%, Hewlet

Microsoft 4.5%, ASM Lithog

T. Rowe Price Science & Technology (PRSCX) semiconductor 17%, commun’ns equip 14%, software 13% Parametric Technology 4.0%

Network Assoc. 3.4%, First

Fidelity Select Computers (FDCPX) computers 44%, semiconductors 16%, software & servs 11% Dell Computer 10.1%, EMC

Compaq Computer 4.1%, M

Fidelity Select Technology (FSPTX) software 16%, semiconductors 10%, microcomputers 5% Microsoft 9.7%, Selectron 4.

Micron Technology 2.7%, H

Fidelity Select Software & Comput Servs (FSCSX) software 54%, computer servs 10%, data process’g 6% Microsoft 11.2%, PeopleSoft

Siebel Systems 4.0%, Comp

Northern Technology (NTCHX) software & servs 36%, commun’ns equip 21%, Cisco Systems 4.7%, Lucent

electrical & electron compon 20% Dell Computer 4.4%, Yahoo

Robertson Stephens Information Age (RSIFX) software & servs 34%, semiconductors & compon 14%, Legato Systems 4.3%, Amer

commun’ns equip & servs 10% SAP AG 3.7%, Vitesse Sem

INVESCO Strategic Technology (FTCHX) software & servs 25%, computer hardware 13%, IBM 4.3%, Lexmark Int’l 3.2%

data process’g servs 10% CBT Group 2.8%, Ceridian 2

PBHG Technology & Communications (PBTCX) technology 63%, services 24%, health care 2% Ascend Comm 4.8%, J.D. Ed

Citrix Systems 4.0%, Comp

Fidelity Select Develop Commun (FSDCX) telephone equip 14%, telephone servs 12%, Cellstar 9.7%, Brightpoint 7.

wholesale electric appliances 10% Alcatel Alsthom 5.5%, Noki

Fidelity Select Telecommun (FSTCX) phone servs 47%, data commun equip 6%, WorldCom 8.6%, MCI Comm

TV & radio commun equip 5% AT&T 5.0%, Global Telesys

Source: Quarterly Low-Load Mutual Fund Update for statistics, with returns through Sept. 30, 1998; portfolio information supplied by the funds.

each fund with the percent of theportfolio by value invested in eachsector. In terms of the health carespectrum, Fidelity Select Biotechnol-ogy, with 43% in biotech, is at oneend, and Fidelity Select Medical

Delivery, with 35% of the portfolioinvested in the hospital category, isat the other end. These funds arelisted in rough order from thosecommitted significantly to biotech,through those that include drugs and

pharmaceuticals, medical devicesand, broader still, medical services.But funds report subsections andindustries differently, so sectorgrouping may be something differentfor each fund.



e of Portfolio)e of Portfolio)e of Portfolio)e of Portfolio)e of Portfolio)

2%, Genzyme 5.8%, 62 162 1.49 3.00% front –1.0 11.5 10.6 16.7 –15.4 1.56

gh 4.4%

s 3.2%, Pfizer 2.7%, 77 133 1.35 none 0.5 na na 12.5 –15.4 na

onal Data 2.4%

Squibb 6.4%, Warner-Lambert 6.4%, 56 143 1.08 none 24.3 22.4 23.3 11.4 –10.5 1.26

erican Home Products 5.3%

r 5.2%, Pharmacia & Upjohn 5.1%, 99 10 0.40 1.00% 19.7 27.0 26.5 10.0 –10.5 0.96

, Abbott Laboratories 3.6% redemption fee

.9%, Warner-Lambert 7.6%, 62 59 1.33 3.00% front 29.3 27.1 29.7 11.6 –10.4 1.09

Squibb 4.9%, Schering-Plough 4.9%

alth Management Assoc. 8.0%, 49 109 1.57 3.00% front –17.0 6.3 14.6 12.0 –22.6 1.61

mbia/HCA Healthcare 5.7%, Tenet Healthcare 5.6%

t-Packard 5.9%, 104 435 1.18 3.00% front –25.6 11.2 25.4 17.4 –19.9 2.27

graphy 4.5%, Texas Instruments 3.3%

%, Analog Devices 3.5%, 51 125 0.97 none –15.5 4.4 15.6 14.9 –22.6 1.87

Data 3.3%, Maxim Integrated Products 3.2%

7.7%, Quantum 5.9%, 71 333 1.40 3.00% front 5.5 17.8 29.7 23.1 –14.0 2.29

Microsoft 4.1%

.2%, Dell Computer 4.0%, 108 556 1.38 3.00% front –4.2 11.9 20.2 17.5 –17.5 2.04

HBO & Co. 2.4%

t 7.5%, BMC Software 6.8%, 67 145 1.44 3.00% front 12.0 19.0 20.1 22.1 –18.3 1.96

puware 3.3%

t Technologies 4.5%, America Online 4.4%, 70 74 1.25 none 5.8 na na 18.0 –20.2 na

o 4.3%

rica Online 4.3%, Netword Assoc 3.7%, 46 369 1.82 none –16.0 na na 20.8 –24.4 na

miconductor 3.2%

%, Int’l Game Technology 3.2%, 120 237 1.05 none –9.3 12.5 16.0 10.9 –17.7 1.52

2.8%

dwards 4.6%; 64 259 1.30 none –19.7 21.6 na 17.3 –16.6 2.04

uware 3.9% Saville Systems 3.6%

.3%, Anicom 6.8%, 55 383 1.61 3.00% front –4.1 5.5 13.3 14.1 –20.3 1.96

a 4.3%

mun 7.5%, Tel-Save Holdings 6.6%, 31 157 1.51 3.00% front 7.1 12.5 13.4 14.2 –22.9 1.61

stems Group 3.6%

S&P 500 IndexS&P 500 IndexS&P 500 IndexS&P 500 IndexS&P 500 Index 9 .09 .09 .09 .09 .0 22 .522 .522 .522 .522 .5 19 .919 .919 .919 .919 .9 8 .08 .08 .08 .08 .0 –14.4–14.4–14.4–14.4–14.4 1 .121 .121 .121 .121 .12

S&P MidCap 400 IndexS&P MidCap 400 IndexS&P MidCap 400 IndexS&P MidCap 400 IndexS&P MidCap 400 Index –6.2–6.2–6.2–6.2–6.2 14 .114 .114 .114 .114 .1 13 .613 .613 .613 .613 .6 9 .99 .99 .99 .99 .9 18 .618 .618 .618 .618 .6 1 .321 .321 .321 .321 .32

Russell 2000 Small-Cap IndexRussell 2000 Small-Cap IndexRussell 2000 Small-Cap IndexRussell 2000 Small-Cap IndexRussell 2000 Small-Cap Index 19 .019 .019 .019 .019 .0 6 .86 .86 .86 .86 .8 9 .09 .09 .09 .09 .0 11 .111 .111 .111 .111 .1 –19.4–19.4–19.4–19.4–19.4 1 .421 .421 .421 .421 .42

Annual ReturnAnnual ReturnAnnual ReturnAnnual ReturnAnnual Return One-Month ReturnsOne-Month ReturnsOne-Month ReturnsOne-Month ReturnsOne-Month Returns (as of 9/30/98) (as of 9/30/98) (as of 9/30/98) (as of 9/30/98) (as of 9/30/98) Last Three YearsLast Three YearsLast Three YearsLast Three YearsLast Three Years TotalTotalTotalTotalTotal

No. ofNo. ofNo. ofNo. ofNo. of Portfol ioPortfol ioPortfol ioPortfol ioPortfol io ExpenseExpenseExpenseExpenseExpense MaximumMaximumMaximumMaximumMaximum One-One-One-One-One- Three-Three-Three-Three-Three- Five-Five-Five-Five-Five- High-High-High-High-High- Low-Low-Low-Low-Low- R iskR iskR iskR iskR iskStocksStocksStocksStocksStocks TurnoverTurnoverTurnoverTurnoverTurnover RatioRatioRatioRatioRatio LoadLoadLoadLoadLoad YearYearYearYearYear YearYearYearYearYear YearYearYearYearYear es tes tes tes tes t es tes tes tes tes t Index Index Index Index Index

(%) (%) (%) (%) (%) (%) (%) (%) (%) (%) (%)(%)(%)(%)(%) (%)(%)(%)(%)(%) (%)(%)(%)(%)(%) (%)(%)(%)(%)(%) (%)(%)(%)(%)(%) (%)(%)(%)(%)(%)

As for individual stocks, Merck isthe most prevalent in the top fiveholdings, but all the major drug/pharmaceuticals makers are there:Warner-Lambert, Bristol-MyersSquibb, Schering-Plough, Pfizer,

Pharmacia & Upjohn, and AmericaHome Products. Fidelity SelectBiotechnology and T.Rowe PriceHealth Sciences tend to hold morebiotech drug companies—higher risk,higher return, drug development

stocks.How diversified are these sector

funds? A diversified sector fund issurely an oxymoron, but the under-lying question is: how concentratedis the portfolio? Fidelity Select

6 AAII Journal/November 1998


Biotechnology, for example, holds62 stocks, but 43% of the portfoliois in biotech and 10.4% is in onestock, Genentech, while the top fivestocks make up 32.5% of theportfolio. Contrast this with T.RowePrice Health Sciences, which has 77stock holdings, 25% in pharmaceuti-cals as the top sector holding,Collagen as the top stock at 3.7%,and the top five stocks totaling only14.7% of the portfolio. Even amongsector funds, diversification is anissue that should be addressed. Themore concentrated the sectors, topstocks and number of total stocks,the more likely the fund is to havehigher risk.

Portfolio turnover ratios give someindication of how aggressive thesefunds transact. Portfolio turnover isthe lower of purchases or sales as apercentage of portfolio value on anannual basis. A 100% turnover,about the average for a stock fund,indicates a complete turnover of theportfolio by value, not necessarily achange in all stock holdings, how-ever. Vanguard Specialized HealthCare is barely actively managed,with a 10% turnover, while FidelitySelect Biotechnology at 162% isaggressively managed—two differentinvestment management styles.Beyond brokerage costs, which aresmall per share at institutional rates,there is still the cost of the bid-askspread, the difference between thebuy price and sell price, a quarterpoint (0.25%) or less for large liquidstocks but higher for less liquidsmaller stocks. Brokerage costs andspreads reduce fund returns. Themore turnover the greater thetransaction costs, brokerage fees,and spread for a fund.

The expense ratio is a measure ofportfolio return drag. Expressed as apercentage of the portfolio value, theexpense ratio includes all manage-ment fees and fund costs, including,if the fund assesses one, the annual12b-1 distribution (marketing)charge, but does not include broker-age costs and front-end loads, back-end loads, or redemption charges.

The average expense ratio foraggressive growth funds, how mostof these funds would be classified, is1.3%. Vanguard Specialized HealthCare, demonstrating its fund family’sphilosophy, has a very low 0.40%ratio. The only fund noticeablyhigher than the average is FidelitySelect Medical at 1.57%, althoughnot high enough to sound an alarm.Returns for mutual funds arereported net of expenses, so theexpense ratio in essence has alreadybeen subtracted from the perfor-mance figures.

For each of these health sectorfunds, one-year, three-year, and five-year annualized returns are reportedand for comparison the returns forthe Standard & Poor’s 500 index(large stock benchmark) and theStandard & Poor’s 400 (mid-sizedbenchmark) are given. Two riskmeasures are provided to judge thesefund’s returns. The first risk measureis simple: What is the best and worstone-month return over the last threeyears? The second risk measure is aratio of the return volatility of thefund to the average return volatilityof all mutual funds. A 1.00 ratiowould be equal to the average totalmutual fund risk, and a ratio of 2.00would be twice as volatile, forexample.

With the exception of VanguardSpecialized Health Care, and to alesser extent, Fidelity Select HealthCare, these are volatile sector funds.A drop of 10.0% in a month duringa period without a bear marketwould take the breath away frommany investors. But these funds alsohave the upside, 12% and even 16%in a month. As a group over the lastthree years, those funds invested inthe large drug stocks did the best,hospital/medical delivery probablythe worst and biotech somewhere inbetween, three patterns within onegrowth sector.

TECHNOLOGY FUNDS

Technology breaks down intothree primary subsections based

upon the holdings of these sectorfunds: semiconductors, software, andcomputer hardware. The technologysector funds are roughly listed in thisorder so that funds with relatedsector allocations are close by foreasier comparisons. Looking at thetop five holdings column, it is clearthat many holdings are Microsoftand the computer makers: Gateway2000, Dell, Compaq, and IBM. AndInternet stocks have a presence withAmerica Online, Yahoo and others.Remember that the two telecommu-nication sector funds, Fidelity SelectDeveloping Communications andFidelity Select Telecommunications,don’t really fit the category; they area stretch to call technology but arehere for comparisons and informa-tion.

As a group, technology sectorfunds are more spread out byindustry and stock holdings than thehealth sector, getting back to thequestion of just what is technology.For example, PBHG Technology andCommunications has 63% intechnology, however they definetechnology.

About a third of these funds holdmore than 100 stocks. INVESCOStrategic Technology holds 120stocks, far more than required to bediversified, and its top five stockholdings add up to only 16.3% ofthe portfolio.

Portfolio turnover ratios of someof these sector funds can be shock-ingly high; 556%, 435%, 383%.These are aggressive funds investingin high growth, high-risk stocks, andthe technology area has been inconstant evolution, reshaping itselfrapidly. And some of these expenseratios—Robertson Stephens Informa-tion Age at 1.82%, for example—are on the high side. As a group,technology funds have highertransaction costs and expenses,which are easily forgotten if theyperform well.

Some of these funds beat the S&P500, a tough benchmark to best,recently and over five years. But therisks were equally tough to beat.



The two funds that far outdid theS&P 500 (19.9%) over five yearswere Fidelity Select Computers(29.7%) and Fidelity Select Elec-tronic (25.4%), but they had totalrisk ratios of 2.29 and 2.27 respec-tively, well more than twice the riskratio of the 1.12 for the S&P 500.And don’t overlook the monthextremes, a few up over 20.0% in amonth and those same ones downover 14.0% in another. That isvolatility that few funds everdisplay.

A SECTOR FUND CHECKLIST

Additions of health and technologyfunds are sure to alter a portfolio’scharacter with the promise of highreturns and the likelihood of occa-sional nose dives. Before you investin any sector fund, make sure youget an annual report and prospectusand check off these points:• What is the investment objective

of the fund (how does the fundcharacterize its sector)?

• What are the top three subsectors

and what percentage do theyrepresent of the portfolio?

• Do these subsector weightingsmatch the investment objective asyou understand it?

• What are the major stock holdings?• Does this fund fill in gaps in your

portfolio or is it overlapping?• How has this fund performed

against similar sector funds andagainst basic market benchmarks?

• How jarring have the performancepotholes hit by the fund been andcan you stand the ride? ✦✦✦✦✦

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s: h

ow c

once

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ted

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he p

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? Fi

delit

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lect

mutual funds workshop health and technology: high-powered

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