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Diana Mackay examines the emergence of sector funds
Mutual funds in Europe have stepped out of the department store and on to the catwalk. Gone are the days of investors’ choice being limited to the plain vanilla domestically invested money market and bond and equity funds. With interest rates set at a low point for the foreseeable future, investors are looking to spice their portfolios not only with more exotic international exposure, but also, increasingly, in so-called theme or sector funds.
The story is one of evolution, with a timeframe accelerated by European economic and monetary union. Ten years ago the number of mutual funds was around 6,000 and, for many European investors, the collective investment opportunity was only just beginning to take off.
Of the largest 50 funds at that time, only two had a mild sector flavour, both insurance-linked vehicles. The latest data from Lipper (June 1999) reveals a market of some 18,000 funds and offers a sector fund as the third-largest equity fund in Europe.
With some $5.6bn (e5.4bn) in assets, Telemedien, the telecom fund from Germany’s Deka, belies the commonly-held belief that European investors are unusually risk averse.
For an industry that thrives on innovation, the move towards sector funds was inevitable. However, the speed with which they have found favour has been recent and quite dramatic. The steady reduction in interest rates across Europe has encouraged investors to step up the risk ladder, but market conditions have also played their part.
The introduction of the euro, which made geographically focused investments (at least within the European region) less distinctive, and the generally lacklustre performance of some of these markets, have combined to attract more adventurous savers into more focused investment opportunities.
Added to this has been the ‘sizzle’ of the fast-moving internet and telecom stocks on which US investor fortunes appear to be in the making.
But sector funds are not just about ‘sizzle’. They are an ill-defined breed of funds covering a range of investment activity from passively managed indexed funds to the higher risk industry-focused funds.
More specifically, there are three categories of sector fund. The first is industry specific, for example, telecom, biotechnology and health care.
The second is style specific, such as index trackers, blue-chip and small cap. The third sector is client specific, whereby fund investment is based on a particular client focus, such as asset allocation funds, or those aimed at the youth market or at particular professions.
The first two types of funds require specific performance categories to ensure appropriate comparison. The third category of fund is distinctive more for the marketing wrapper that is used than for a new and unusual investment style. They are included in this analysis to illustrate further the colour and creativity that has recently entered the fund scene.
Sector funds appear to be the height of fashion but how real is the trend? Also, to what extent is appearance based on fact or simply enhanced press attention on a small number of ‘sexy’ funds? An accurate assessment of the phenomenon is difficult because of inadequate and diverse forms of fund categorisation in Europe. However, the best view of change is in the focus of new fund launches. Taking Lipper data on all new fund launches in Europe during the 12-month period between June 1998 and June 1999, of 886 equity funds launched just over one-quarter (227) clearly fell into one the sector categories listed above. Five years earlier, the number of new fund launches falling into this generic definition of sector was 87, with the bulk in the style categorisation of small cap and index tracker (see table).
Clearly, there has been a shift in favour of industry sector funds. Moreover, indications are that there are many more to come and the variety of industries in which they are focused is growing in a direction that is even more imaginative than in the US. Nevertheless, the less risky index tracking funds dominate the 1999 list providing a counter-balance to the impression that European investment patterns have moved from the sublime to the ridiculous.
Market performance is at the heart of the trend. In an industry that is increasingly driven by fund performance, promoters need to find that edge – that pinch of spice that will differentiate their funds and thereby attract new clients. In the last year, a number of industry specific sectors and Far Eastern markets (in particular Japan) have outperformed the European markets. In Germany, for example, Japanese Smaller Companies funds ranked top with a percentage growth of 159% since the beginning of the year. The fifth-best performing sector was technology (51.8%), followed by natural resources (49.9%). In comparison, the German equity sector posted a return of 3.4% over the same time period.
The attractions are obvious. The unanswered question, though, is whether investors really understand the risks they are taking with some of these high-performing sectors. Will a sharp downturn, for example, in the technology sector cause German investors to retreat from equity funds altogether?
We do not yet have enough experience to answer this question but, given the range of equity funds, investors are more likely to stay with equity funds but perhaps retreat down the risk ladder towards index tracking funds.
Greater variety of equity funds means greater choice for investors. The challenge, though, for the providers and advisers is in establishing a common base of comparison for these funds. Currently each European country has established categories for performance comparison. In the main, these categories are plain vanilla in their orientation and do not tend to take account of the diversity of fund products coming on to the market. Moreover, even at the base level of defining equity, bond and balanced categories, the asset allocation rules vary from country to country. In this environment cross-border comparison is difficult and inadequate. Choice, therefore, will continue to be restricted until data providers are able to deliver a flexible and transparent system of categorisation that enables comparison across Europe at the asset type, geographic focus and sector levels.
For the time being product innovation is moving at a speed that is faster than regulators, trade associations and data providers can respond to. And, the transportation of new ideas from the US suggests that we may soon be seeing imaginative designs such as webs, spiders, diamonds, vulture funds, micro-caps, and enhanced indexing!
Diana Mackay, is managing director of European Fund Industry Services in London

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