FUND FLAVOUR

October 2015

Mutual funds which invest in a particular sector or industry are said to be sector-specific funds. These funds seek to predominantly invest in the sector/theme stated in the offer document. A FMCG fund for instance, invests in consumer plays and their proxies while a banking fund invests in banking and financial services-oriented stocks. A theme, on the other hand, can be slightly broader – like investing in MNC stocks or lifestyle-related stocks, or investing in certain international regions and so on. That means, instead of taking limited exposure in sectors/themes the way diversified funds would, sector funds place all their eggs in one basket, taking focused bets, thereby increasing the concentration risk. To that extent their risk-reward ratio is expected to be higher than diversified equity funds. Since the portfolio of such mutual funds consists mainly of investment in one particular type of sector, they offer less amount of diversification and are considered to be risky. Their performance is aligned with the performance of the sector in which they are investing. As the exposure is not broad based, it carries a high degree of risk. This type of funds is normally suitable for a highly aggressive investor.

Performance of some of the sector-specific funds is elaborated below:

Infrastructure Funds – back in favour

Equity mutual funds that invest exclusively in shares of firms engaged in the infrastructure business are back in the reckoning. With the market rally sending infrastructure stocks higher, equity funds that invest in these sectors have emerged as the second biggest gainers among mutual funds gaining 18%, next only to the banking sector. The BSE Capital Goods Index posted the highest increase among stock indices in the current year, gaining 26%. Banking and infrastructure sectors are seen as the proxy for the economy. With the economy slowly climbing its way out of its worst slump in a decade amid expectations that the government at the centre would give the much-needed thrust to recovery, these sectors have gained traction. Since the economic slowdown has bottomed out, we would see growth. A revival in the investment cycle and moderation in interest rates would help infrastructure companies, which are highly leveraged, post higher growth. The sharp recovery in the past few months has, however, not helped infrastructure equity mutual funds to substantially improve their abysmal record over the long term. They posted measly 5.6% and 1.6% annual returns respectively during the three-year timeframe pushing them to the bottom of the performance chart. There is still value left in these stocks as they have taken a beating in the past few years.

Banking Funds – on a roll          

The banking sector, especially the PSU pack, was on a roll. Some recent measures taken by the government include that of capitalisation of PSU banks and the announcement of the seven-pronged PSU banks' revival plan ‘Indradhanush’. The markets reacted positively to these long-awaited measures for the growth of PSU banks. Capital infusion by itself may not help as has been seen in the past. Revamping management and governance in PSU banks also needed to happen. Both these steps concurrently may put some things in the right place but the biggest concern of the banking sector, the high and rising levels of non-performing assets (NPA), still remained unanswered by these measures. What matters the most in banking sector funds is the NPA. According to Economic Survey, 2014- 2015, gross NPA increased from 4.1% (March 2014) to 4.5% (September 2014). CNX PSU BANK index was up by nearly 6.19% with all 12 stocks ending on a positive note. Bank of Baroda and Canara Bank rose in double digits clocking 14.99% and 12.87% respectively. If one is optimistic about the economy by expecting it to do well over the next 2-3 years, banking sector funds should be a part of the portfolio. Choose funds that a have a mix of PSU and private sector banks. Since majority of such funds are heavily invested in ICICI Bank, HDFC Bank, and AXIS bank, careful choice is necessary for diversification.

Technology Funds – losing fancy?

Mutual funds that focus on IT stocks have delivered much higher returns than the Nifty and Sensex across one, three, and five-year periods. For the last one year, the sector funds averaged a 9.6% return, while the Nifty and Sensex suffered losses of 3.6% and 5%, respectively. Three-year returns on these funds at 26% beat the bellwether by over 12 percentage points. And for the five-year period, IT funds managed 14.5% while the market has only delivered 7%. Investments made in IT funds as a diversifier would have paid off well in the last five years, due to the sector’s defensive nature and ability to gain from rupee depreciation. There are five technology funds and these funds have also managed good performance against the sector indices — the BSE IT index and the BSE Tech index. The sector was a strong performer from the low of 2013 until February 2015, with the BSE IT index hitting its all-time high at around 12,000 in March 2015. But thereafter, rupee volatility and disappointing earnings from the frontline players have eroded fancy for the sector. While there is a fair degree of earnings visibility, growth is likely to slow down over the next couple of years as the larger players grapple with stiff competition and reinvent themselves to move up the value chain. 

Auto Funds – early cyclical plays

The automobile industry of any nation is a key indicator of its progress, and India is no different. According to estimates, this industry accounts for nearly 7% of India’s Gross Domestic Product and employs close to 1.9 crore people directly and indirectly. Research shows that India, which is the sixth largest automobile market in the world, is set to zoom ahead of its competitors in the near future. The UTI Transportation and Logistics Fund has earned more than double the benchmark index, a staggering 137% as against the benchmark return of 65%. Autos, commercial vehicles, and other auto ancillaries would be early cyclical plays, with automobile sector mutual funds delivering outstanding returns.

FMCG Funds – getting expensive

The FMCG sector is performing well due to strong characteristics and dependence on consumption in the domestic market. In the last 15 months, the FMCG sector attracted many investors and gave strong returns to them. The other sector indices gave negative returns in the range of 2% to 38% due to slowdown in the economy, high interest rates, and rising inflation. BSE FMCG index is currently not cheap. It is trading at price to earnings ratio multiple of 27 times one year forward earnings as compared to BSE SENSEX now valued at around 13 times the forward earnings. The FMCG sector valuations are at 108% premium over the SENSEX. According to Nielsen’s research report entitled “Consumer 360”, the Indian FMCG market is estimated to grow to USD 100 billion by 2025 from USD 13 billion in 2012. According to the report, the key areas driving this growth would be increased sales and acceptance of branded products, regular consumption of FMCG goods, etc. However, this growth will not be smooth. There will be some untimely jerk led by economic slowdown, increase in inflation, etc. It is advisable to stay invested in this sector for long term to gain strong profits. 

Pharma Funds – a safe bet

Healthcare or Pharmaceuticals is a sector that has outperformed the broader market over the last one year period. In terms of returns, the BSE healthcare Index has delivered a very healthy 28.1% returns in the last one year, while the Sensex has delivered only about 4.6%. The one year returns of the pharma funds range from 50% to 65%. While the depreciation of the rupee versus the US dollar has helped exports in this sector, the domestic pharma market growing at double digits, has resulted in strong revenue growth for companies in this sector. The pharma sector funds are often seen as an excellent defensive bet in weak market conditions. However, there are certain risks associated with this sector, primarily due to government regulations both overseas and in India. Headwinds are seen from the demanding US FDA guidelines, which may potentially impact exports, unless the companies are able to ensure compliance with the guidelines in their domestic manufacturing plants. The Indian government’s drug pricing policies have also impacted margins. Despite the headwinds, the future outlook of the sector remains positive due to high current account deficit and lower capital inflows implying that the rupee will continue to be under pressure, which will ensure the continued competitiveness of the sector. A number of drugs will go off patent in the next few years. This augurs well for the generics segment and the Indian pharma sector. The government also plans to increase health expenditure to 2.5% of the GDP by the end of the 12th Five-Year Plan (2012-17), which will give the sector another big boost. Changes in government policies, industry specific issues, and technological developments may impact the healthcare sector, either in a positive or a negative way. Pharma and Health care sector has been evergreen and is expected to continue to do well in the next few years.

PSU Funds – changing perceptions

PSUs come with some negative baggage and perceptions but this perception has changed over time and is slated to change more in the near future. For the period between October 2010 and August 2013 the BSE PSU fund was in doldrums as the public sector valuations were very low. Bargain hunting from September onwards propelled interest in public sector companies once again. BSE PSU Index has surged by 61% since March 2014. The change in trend was due to the expected change in Government. Over the past one year, these funds have delivered about 36% returns, which is 4-5 percentage points better than what the Sensex or the Nifty managed. All the PSU funds have a track record of less than five years. Most of them have beaten the BSE PSU index over the past three years by delivering an average return of 3.6% over the index return of 0.9%. But in the last one year Baroda Pioneer PSU Equity Fund - Plan A has outdone the benchmark index’s return of 37% by delivering 43%. Three other funds have underperformed the BSE PSU index. Religare Invesco PSU Equity, which has outperformed peer funds over three years, is among the lower performers over the one-year period. For all the funds, exposure to the stocks of companies such as ONGC, HPCL, Coal India and NTPC helped returns. Power and mineral companies too found favour. In addition, stakes were also increased in the banking space, which rallied strongly over the past couple of months. Baroda Pioneer PSU Equity Fund - Plan A took exposure to banks, oil, mineral and power, allocating 73.5% of its portfolio to such segments. Religare Invesco PSU Equity too was overweight on sectors such as banks, power, oil, mineral, petroleum products and gas over the past one year. SBI PSU fund too played the trend well, betting mostly on winning stocks. Sundaram PSU Opportunities churns its allocations constantly. Energy, Financial Services, and Metals are the top preferred sectors with an allocation of 80% of its portfolio.

If you are investing in a sector fund, do you know enough about the sector and believe it is a good time to invest? Are you willing to closely track performance of the sector vis-a-vis your fund’s? Would you know when the sector looks overheated and move out? Are you willing to book losses and exit if it becomes evident that the sector is not going to revive in a hurry? If you are willing to do these, then here are a few simple suggestions. Let a sector fund be part of a tactical allocation. Avoid adding them in core family goals such as education or retirement. Restrict allocation to about 10% of your fund exposure at the most. Avoid long periods of SIPs in sector funds (contrary to diversified funds) if you enter in an up-phase. There is little point averaging when the sector is headed in one direction – up. Similarly, do not keep averaging when a sector falls. You may be throwing good money after bad! Sectors such as FMCG and pharma can contain declines to some extent but not others such as infrastructure or banking or media and entertainment. Hence, be aware of what to hold for a defensive strategy.