Sector Funds -- Mid-Year 2002 Review

Manager Fred Sturm of Ivy Global Natural Resources has been increasing his exposure to energy stocks and trimming his exposure to gold of late. "When we drill down to a company level, the resource producers are still in fine shape," says Sturm. "They are basically all still making money, and basic industries are all still holding firm and showing a tendency to outperform the market and to hold better than other sectors." The fund's energy weighting is currently 55%-60%. One area the Sturm is currently interested in: the opportunity in electricity producers and energy generators, shaken after the fallout following Enron.

Financials

Sector funds investing in financials were up just 0.5% as of the end of June, pulling back in the second quarter after being shaken by bad news and market declines. FBR Small Cap Financial Fund/A (FBRSX), a top performer, rose 19.5% as of mid-year by continuing to focus on small-cap regional banks and thrift institutions. Diamond Hill Bank & Financial Fund/A (BANCX), also a strong relative performer, is up 16.2% over the same period. The top performer in the group was Emerald Select Banking & Finance Fund/A (HSSAX), which rose 19.8%.

Although manager David Ellison of FBR Small Cap Financial can buy anything in the financial services sector, small banks and thrifts are attractive because they have uncomplicated business models, generate fairly predictable earnings, and are less risky than large-cap financial companies right now since they make safer loans at smaller balances. "If you are making money in middle America, it doesn't change that much," says Ellison on the characteristics of his holdings. "The middle of America doesn't go bankrupt, it doesn't become overvalued."

Technology

Tech funds were down 34.3% on average as of mid-year, achieving most of the losses — roughly 30% — during the second quarter as the market deteriorated and punished aggressive growth-oriented segments of the economy. The best relative performers as of the end of June included Matthews Asian Technology Fund (MATFX), which fell 7.2%, Franklin Custodian Fds:DynaTech Series/A (FKDNX), down 12.4%, and Kinetics Internet Emerging Growth Fund (WWWEX), down 17.7%. Kinetics Internet Fund (WWWFX) also made the list of the five best relative performing tech funds, losing 17.8%. Losses for most tech funds, however, were severe.

Matthews Asian Tech, which invests across Asia, including China, benefited in the first quarter from the anticipation of a recovery in the U.S., and has been aided by stronger domestic demand for technology in Asia versus the U.S., notes Paul Matthews, chief investment officer of the Matthews Funds. Going forward, Matthews believes that the outlook for domestic demand in Asia is still clearer than in the U.S. He is more confident that high tech firms in Asia will continue to sell products into the Asian markets than he is of a strong recovery in export demand, while the U.S. will need to see a pickup in corporate spending in order to recover.

Health & Biotech

Funds investing in health care and biotech also have shown steep losses so far this year. The average health care sector fund fell nearly 25% as of the end of June, dragged down, in part, by biotech shares. Biotech funds, in particular, have been some of the hardest hit portfolios this year, many losing over 40%. "The biotechs, I believe, are sort of a hostage to the Nasdaq," notes Alidad Mireskandari of Orbitex Health & Biotechnology/A (ORHAX), which lost 33.5%. The fund's weighting in both biotech shares and big pharmaceutical stocks were a drag in the second quarter.

The best relative performing health care funds so far this year include ICON Healthcare (ICHCX), which rose 1.1%, and Vanguard Health Care (VGHCX), which lost 6.5%. ICON Healthcare achieved gains in the sector by avoiding both large-cap pharmaceuticals and biotech shares, focusing instead on health care services, including health care facilities and managed care distributors and suppliers.

The managed health care industry has continued to perform well recently, notes James Callahan, chief investment officer of Meridian Investment Management, advisor to the ICON funds. Callahan says he expects the fund to remain invested in the same industries over the next five months or so. Though he is finding some large-cap pharmaceuticals on sale, he doesn't believe it is their turn to outperform yet.

Note: Sector fund averages are as of 6/21/02 — latest available at this writing.