In complete contrast, Hotchkis & Wiley Small Cap Value Fund, which failed to participate in the 1997-1999 boom, was among the top funds during the 2000-2002 slowdown. Following the 30% loss for the two-year period ending June 30, 2000, Hotchkis gained 88% during the two-year period ending June 30, 2002.

Impact on Sector Funds

Like diversified funds, certain sector funds tend to perform better during some phases of the business cycle. Sector funds that invest in economically sensitive sectors such as technology typically tend to perform better during expansion phases. Sector funds that invest in economically less sensitive sectors like consumer staples typically tend to perform better during contraction phases. As a result, a sector fund that performs best in one time-period may not perform as well in another time-period.

Among the 41 Fidelity sector funds, Fidelity Select Energy Services was the top fund in 2005 with a 54% gain. However in 2003, the same fund gained just 8% to be the worst performer.

Constructing an All-Weather Portfolio

Can one select the top fund by knowing what stage the business cycle is in? Unfortunately, things do not get that easy.

Getting the turning points of the business cycle right is less than a science. Although certain styles and sectors are expected to do better during particular stages of the business cycle, there is no certainty they will do so each time. Additionally, stock prices tend to anticipate and lead the business cycle. The performance of a fund therefore usually varies from one economic cycle to another.

So, rather than chase the top funds, a prudent course is to construct a robust, all-weather portfolio.

A) Constructing with Diversified Funds

One way to construct an all-weather portfolio is to use diversified funds that emphasize different types of market capitalizations and investment styles. To simplify the task, one may construct a portfolio using a large cap-growth fund, a large cap-value fund, a small cap-growth fund, and a small cap-value fund.

In evaluating funds in each category, focus on the long-term track record and see how the funds have fared in different market environments. Complement this by evaluating each fund on non-performance-based metrics such as manager tenure, price volatility or risk, mutual fund fees, and mutual fund fiduciary grade. Choose the best available fund in each category and build your portfolio with managers of a ‘dream team’ caliber.

Alternatively, if you want to restrict yourself to only one fund to start with, you may consider a total market index fund which spans all capitalizations and styles.

B) Constructing with Sector Funds

Sector funds can also be used to construct an all-weather portfolio. This approach offers the advantage of creating customized diversified portfolios by including sectors and industry groups which are likely to outperform the market indexes and excluding those which are likely to under-perform.

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