FUND FLAVOUR

October 2016

Sector mutual funds are those mutual funds that restrict their investments to a particular segment or sector of the economy. Also known as thematic funds, these funds concentrate on one industry such as infrastructure, banking, technology, energy, real estate, power, health care, FMCG, pharmaceuticals, etc. The idea is to allow investors to place bets on specific industries or sectors, which have strong growth potential. 

PERFORMANCE OF SECTORAL FUNDS

Infrastructure funds as a category delivered strong returns of 63% during the 2014 rally when cyclical stocks sky-rocketed on hopes of big-bang reforms. But these funds lost steam in 2015, as buoyant expectations soon gave way to a renewed downturn. Most funds closed the year with minor losses of 0.5%. However, prospects of a pick-up in the reforms momentum rekindled hopes. It is no surprise then that infrastructure funds have bounced back over the last one year. The top five infrastructure funds with a corpus of over ₹100 crore have gained 18.2%, much higher than S&P BSE Sensex which gained 11%.

Banking funds were under performing in the last 6 months to 9 months. The main reason is due to provisioning guidelines for NPA by RBI. Most of the banking stocks took a beating up to 80% of the stock price. In the last few weeks, the stock prices are going up.

FMCG funds continue to remain consistent performers and have been best performers in the last year.

Pharma funds continue to underperform on negative news flows and are the worst performers last year. However, over a longer period of time, they remain the best performing category.

IT funds are among the worst performing category as concerns impact on business and IT spending post Brexit and lower guidance by the managements have impact on stock prices.

PSU funds gave 4-5% higher returns when compared to Sensex or Nifty last year.

ON THE WEIGHING SCALES

There are advantages to investing in a sector fund.

Diversification:  Rather than going with a single stock, you go for a bouquet of stocks in the same sector. By investing in a sector fund, you do diversify risk among the stocks in the same sector. A specific stock may suffer or perform badly due to a company specific development but the other stocks in the same sector will provide the cushion.

Fund manager expertise:  A fund manager, using the research resources at his disposal, is more likely to choose the best stocks in a sector than an average investor.

Better returns:  If your conviction and research about a sector is right, you do stand to reap better than market profits. Sectoral bets, if you get them right, can give you handsome returns.
Even as investors in mid- and small-cap equity funds are sitting on handsome gains made over the past few years, sector-focused funds have delivered higher returns over a longer term. A look at the 10-year performance of mid- and small-cap schemes shows that these have delivered a return of 15% CAGR (compound annual growth rate), compared with around 18% by funds focused on banking, pharma and FMCG sectors. 

In effect, sectoral funds provide a tactical exposure to the investor's portfolio. If you pick the right sector, you stand to reap higher rewards than you would by investing in the broader market. In the past five years, for instance, pharma and FMCG-focused funds, the so called defensive bets, have clocked 22.7% and 19.8% CAGR, respectively. If you had adopted a tactical position and invested in these funds, your portfolio returns would have exceeded those of the broader market. Unlike a sectoral fund, most diversified equity funds will not go beyond a certain limit in taking a meaningful stance on a sector.

Let us list out a few negative issues associated with investing in sector specific funds.

1.      Timing the market: To grow wealth in stock markets, time in the market is more important than timing the market. Unfortunately, to make money in the sector funds, you may have to learn to time the market especially in the cyclical sectors such as banks, cement, steel, etc. For example, banks (or banking stocks) outperform when the interest rates are low or are expected to fall and underperform when the interest rates are rising. So, to invest in a banking fund, you have to be at the right turn of the interest rate cycle to outperform broader markets. Though you must choose the SIP route to build exposure to such funds, you must close those SIPs and exit position in the sector funds when the sector fundamentals begin to deteriorate.

2.      Low diversification: Sudden adverse development in a particular sector will hit all the funds investing in stocks in that sector. However, the sector funds (that invest solely in stocks in that particular sector) will be hit the hardest. In an equity diversified fund, you would have stocks from other sectors to soften the hit.

3.      Finding good companies in a single sector is not easy: A mutual fund typically invests in at least 15 to 20 stocks. Finding these many good companies in a single sector is not easy. For example, the incumbent central government is expected to give a strong push to infrastructure and housing sectors. This may make you bullish about companies in construction, engineering and real estate. However, if you are asked to name a few listed companies with excellent balance sheet and high standards of corporate governance in construction, engineering and real estate, you would struggle to name even five. The fund mandate does not allow much leeway to the fund manager and pick stocks outside the specific sector. Hence, by choosing to invest with sector funds, you may be betting your money on stocks on low quality companies.

4.      Correlation: If you work with a software company, you salary, future salary hikes and job security are linked to performance of the IT sector. If you concentrate your investment too in the technology sector funds, you are taking higher risk since your salary and investments are correlated with the performance of the IT sector. A slowdown in the IT sector will be a double whammy.

5.      Higher risk: Since this category of funds is exposed to a single sector and only a handful of stocks, it carries a higher risk compared with diversified equity mutual funds. In some funds, the top five stocks often account for more than 50% of the portfolio. A downturn in one or two portfolio holdings can hurt the return of the entire fund even if the broader sector fares well. A traditional diversified equity fund, on the other hand, will typically invest only 25-30% of the portfolio in its five largest bets, thus providing a cushion against a slide in any of its top picks. Also, unlike a diversified fund, the fund manager of a sectoral fund does not have the liberty to move away from the sector even if its performance deteriorates. For example, if the infrastructure sector is doing poorly, an infra fund will have to remain invested in the sector because of its mandate. This leaves investors with a struggling fund. In contrast, a diversified fund's manager has the flexibility to get out of a sector facing headwinds and shift his investments to a sector with better promise.

JUDGEMENT DAY      

Considering both pros and cons of investing with sector funds, equity diversified funds is the way to go. However, if you have strong knowledge about a particular sector through professional experience or otherwise and can judge the impact of various events or government policies on stocks in that particular sector, then it may not be exactly unwise to invest in sector funds. However, investing in sector funds is akin to investing in stocks. You invest in such funds only till the time fundamentals of that particular sector are good. You exit your position as soon as sector fundamentals begin to deteriorate. Hence, though you should still take the SIP route to invest in sector funds, SIPs should be closed as soon as sector fundamentals begin to deteriorate or the industry cycle starts to turn for the worse. Under equity diversified funds, you continue with your SIPs to get the advantage of rupee cost averaging.

KEY CONSIDERATIONS WHILE INVESTING IN SECTORAL FUNDS 

Keep the following suggestions in mind while investing in sector funds:

Fund selection is key 

Fund selection within the chosen sector is, of course, critical. Even though the focus is on one segment, funds within a category come in multiple flavours. This is particularly true in the case of banking and infrastructure funds. For instance, some banking funds are tilted towards private sector banking stocks and NBFCs, which have better asset quality and higher profitability. These have delivered healthy returns for investors, unlike some public sector bank-focused funds, which have yielded poor returns in recent times. There is an even greater disparity in the infrastructure fund basket. These funds are known to invest across a variety of businesses, even those remotely connected to infrastructure. Funds in the pharma, FMCG, and technology basket, on the other hand, are of the same type. Invest only in those sectors where you have strong background knowledge

Take limited exposure 

If you do not have the stomach for the higher degree of volatility of sectoral funds, stay away from this category. Those willing to take the risk should go only for a limited exposure. Stick with only one or two sectoral funds. Having multiple sector funds within your tactical allocation will dilute the entire purpose of taking a focused exposure. Sector funds should not make up more than 10-15% of your portfolio.

Do not look at past returns 

Do not invest on the basis of past returns. Too often, investors gravitate towards the flavour of the season and latch on to a sector when the rally is already under way. The investors who entered at the height of frenzy around the technology sector in 2000 or infrastructure in 2007, ended up participating only in the slide. That is not to say that you should take a contrarian approach and invest in a sector that is out of favour. Invest only if you are convinced that the sector's prospects are improving or it is poised for growth. 

Size matters 

Opt for funds that are relatively large-sized and have a proven track record. If the scheme is too small or a chronic underperformer, chances are the fund house may merge it with another fund from its stables.

Do not invest via SIPs 

While investing in traditional equity funds, investors are advised to take the systematic investment plan (SIP) route. SIPs help ride the volatility over a period of time through cost averaging. However, this approach would not serve well if you are hoping to make the most of a sector upswing. When the sector has picked momentum, there is no point averaging your cost as it will dilute your returns. At the most, you could stagger through 4-5 smaller investments, but not through a long-term SIP.

Have an exit strategy 

Sectoral funds tend to perform differently across market phases and the winners keep rotating. Some funds, particularly those that are cyclical in nature like infrastructure or power, are not buy-and-hold type of investments. Also, do not assume that sectors with stronger fundamentals, such as FMCG and pharma, will always see a secular bull run. You should invest in such funds only till the time the sector's fundamentals are on a strong footing. Greed is not good. Conversely, do not hesitate to pull out of your investment at a loss, if it does not work out as you had hoped. Needless to say, you need to monitor your investment on a regular basis.