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NEW YORK (CNN/Money) -
While the overall stock market is stagnant, a few sectors, such as energy, are producing eye-popping returns.
But financial planners warn that when it comes to funds that focus on such trends, chasing the hot sector could get you in trouble.
Sector-specific funds --either mutual funds or exchange-traded funds that invest exclusively in stocks in a particular sector -- are an efficient way for investors to increase their holdings in a given sector. And some planners say these funds are a better way to get exposure to a sector than buying individual stocks.
"I view them as a nice compromise between a broad market fund and an individual stock holding," said Jim King, director of portfolio management for Rydex Investments' mutual funds. "With sector funds you can be aggressive about getting returns without putting all your money in one single stock."
But there are risks, of course. Investors who buy into sector funds are susceptible to the common mistake of buying in at the wrong time, many planners say.
"My personal philosophy is to not try to over-think and never try to out-time the markets," said Charles Failla, a certified financial planner and principal of Sovereign Financial Group.
"The problem with sector funds is that's the road you are taking. In reality, people love to hear about what's hot. A lot of times people say they want to invest in oil because it is going to go up when in reality it's because it has gone up. It's almost impossible for anyone to talk about the stock market in the future tense."
And when a sector falls out of favor, it doesn't take long for the damage to wreak havoc on returns.
"When a sector falls out of favor it does so pretty quickly," said King. "You don't always have time to get out before the damage gets done."
Given those risks, many financial planning experts agree that these funds are not for everyone.
"You've got a hot oven there," said Vern Hayden, founder of Hayden Financial Group. "If you touch it the wrong way, you get burned. I don't think this is a game most people ought to play on their own, but (sector funds) could work for sophisticated investors who spend time researching and watching their portfolios."
What's hot now
Energy's getting a lot of attention with record high oil prices driving up the shares of energy companies. This can be a good play for more speculative investors who don't mind taking on the extra risks of trying to time the market. But for most investors, experts say, it's best to view sector funds as longer-term investments.
Sovereign Financial's Failla said he recommends drug sector funds to clients with higher risk tolerance, because as large pharmaceutical companies have seen their shares plummet, the stocks have started to look more attractive.
Rydex's King agreed that the healthcare sector looks good long-term, despite negative news plaguing the market such as last week's $253 million jury award against Merck in a Vioxx wrongful death lawsuit and the thousands of other lawsuits the drugmaker faces.
Another sector that's attractive partly is financial services, King said, noting that as the assets of aging consumers grow, managing that money and leaving it to heirs becomes more complex, leading many to turn to financial services companies for advice and investments.
Mutual funds vs. ETFs
Sector mutual funds are not the only way to go. There are currently more than 50 sector-specific exchange traded funds, according to Lipper senior analyst Michael Porter.
Professional investors such as hedge fund managers like sector ETFs because they can use them as a hedging tool by shorting the ETFs of sectors they feel are out of favor. But they can also use them to quickly gain exposure to sectors they feel are in favor in the short term.
The advantage of using a sector-based ETF over a sector mutual fund is that these instruments are more liquid; you can trade in and out of an ETF just like a stock. Also, ETFs can provide cost and tax benefits, according to Porter. For example, if one of your sector ETFs experiences a significant decline in value, you can switch horses without facing tax penalties.
As with sector mutual funds, Porter said investors should be careful to avoid just chasing the winners, and they should also be smart about how much you put into any one ETF.
While Hayden said he is generally opposed to investing in products tied to indexes, as opposed to actively managed funds, "When it comes to sectors or regions or certain countries, I think ETFs can work pretty well. They are easier to work with in a portfolio, especially from the standpoint of being able to sell it or buy it like a stock. In a mutual fund you can't do that."
What not to do
Planners and fund managers agree that, as with any investment, a little common sense goes a long way in avoiding the pitfalls associated with sector fund investing. Step one is to figure out why you're buying a sector fund in the first place and how long you plan to hold onto it.
"As an investor, you need to be consistent and have a plan," said Bill Gerlach, portfolio manager of the Gartmore Global Natural Resources Fund.
"If you want to pull into the hot sector and pull out after six months, that's not a good plan -- it needs to be money you can commit for a couple of years. Don't chase sectors when things are hot and panic when things are cooling off. Take advantage of other people's fear and greed without falling into those traps."
And if you're the type of person who develops agita at the slightest decline in your portfolio, sector funds may not be a good bet.
"Someone who is not going to sleep because they have money in a tech fund, for example, is not well served," said Rydex's King.
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