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Is Your Fund Betting on Overvalued Sectors?

Some equity funds' heavy allocations to pricier areas of the market could spell trouble for shareholders.

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Holding an outsized allocation to a given sector of the stock market can be a boon or a bane to a fund. If the sector outperforms, the fund very well may benefit by participating in more of that gain than its peers do. If the sector underperforms, the opposite may hold true. A fund that's overweight in a significantly overvalued sector carries added risk--namely, the risk that the fund could get hammered if there is a correction in that area of the market.

An overweighting in an overvalued sector doesn't necessarily portend doom for a fund. By picking the right stocks within the sector--meaning those that are not overvalued or that hold up better in a correction--a skilled manager may avoid, or at least mitigate, the negative impact of a sector downturn. For example, the Gold-rated
 Yacktman (YACKX) fund currently holds one third of its portfolio in the consumer defensive sector, which Morningstar's equity analysts say is somewhat overvalued. (By comparison, both the benchmark S&P 500 and the large-blend category average give about an 11% weighting to the sector.) That large a sector overweighting might set off alarm bells in the hands of an unproven manager, but father/son comanagers Don and Stephen Yacktman have a long and distinguished track record that suggests they have a pretty good idea of what they're doing.

Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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