FUND FLAVOUR
October 2017
Although most mutual fund schemes
swear by diversification, there are some schemes that do not diversify. They
stick to one or few sectors and prefer to cash in on their performance.
Sectoral and thematic funds fall in this space. But there still is a big
difference between the two. Sectoral funds aim to invest their entire corpus in
one sector and thematic funds invest in two or three sectors that are closely
related to one another. As the name implies, a sector fund is a mutual fund
that invests in a specific sector of the economy, such as pharmaceuticals,
banking & financial services, FMCG, technology and other sectors like
energy and infrastructure. Sector funds come in many different flavors and can
vary substantially in market capitalisation, investment objective (i.e. growth and/or income)
and class of securities within the portfolio. If you are an informed investor
willing to take higher risks for higher returns, then sectoral funds may be
just for you.
Volatility is the name
of the game
The
performance of sectoral funds has been volatile in recent times. All the pharma
funds which were once celebrated as outperformers gave a negative return of -12
to -16% in the last one year. In comparison, many of the banking &
financial services sector funds have given above 30% and some have given as
high as 37%. The FMCG funds have a decent return profile of 14 to 15% whereas
the technology funds have barely given any return at all as they were lingering
at a combined average of around 2.2% in the last one year. Infrastructure funds
have seen good returns but the long-term performance of the sector depends on
several macro factors which can influence the stock prices in the near future.
The pros …
- A sectoral fund allows you to take a macro call on a sector.
- It is diversified well within a larger sector which gives it more breadth.
- It does not have to be micromanaged by the investors as the portfolio will be handled by the fund.
- A variety of similar funds allows you to choose from the better portfolios between funds.
- It allows you to choose between different sectors by buying multiple sector funds.
- A higher weightage is given to a sector which is not possible in regular diversified funds.
- It paves the way for absolute returns as opposed to relative returns.
and the cons…
- It has a higher volatility of returns when compared to equity diversified funds.
- If the decision turns out to be wrong, the drawdown can be significant.
- It is meant for knowledgeable investors who want to time the market albeit in the long run.
- There is not enough variety to choose from in India.
- You cannot customize the portfolios based on your preferences.
Sectoral funds do
not find a place in most financial plans as these are considered risky because
of their focused exposure. For wealth creation, a mix of diversified equity
funds is prescribed. These are considered safer since the money is spread
across companies from various sectors to limit the risk arising from a downturn
in some industries. Given that sectoral funds are also capable of delivering
high returns, are you losing out by staying completely clear of this category
of funds?
Better 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 (compounded annual growth rate), compared with around 18% by funds focused on banking, pharma and FMCG sectors.
Tactical standpoint
The main purpose of
investing in a sectoral fund is to gain from the concentrated exposure to a
pocket of the economy—FMCG, banking and financial services, infrastructure,
pharma, technology—that is doing well and promises growth in the future. In
effect, sectoral funds provide a tactical exposure to your 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. Once you have the core portfolio in place, it can be a
good idea to take an exposure to sectoral funds from a tactical standpoint. The
additional exposure can provide a boost to the overall portfolio returns.
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. In addition, 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 you 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.
So what should you do? Here are some time-tested
tips that can help you benefit from this category of funds.
Sectoral fund success strategies
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, 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.
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. These funds should not make up more than 10-15% of your
portfolio. Sectoral funds should be used purely from a tactical viewpoint. They
should not be a part of your core holdings, but used to complement the existing
portfolio.
Do not look at past returns
Do not invest on the basis of past returns. Too often, you 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, you 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. Given the smaller quantum of exposure to the fund, you would do well to buy on dips rather than invest through an SIP.
Have an exit strategy
Sectoral funds tend to perform differently across market phases and the winners keep rotating. It is not easy for a common investor to take a call on the future prospects of a sector and time the entry into a sectoral scheme and exit at the opportune time. 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.
The bottomline
The concentrated portfolios of
sector funds can produce tremendous gains or losses, depending on whether the
chosen sector is in or out of flavor. No
particular sector can perform in all market cycles. Thus placing all your eggs
in the same basket would never be a wise decision. A portfolio must be
diversified across different sectors to ensure capital protection, reduce
volatility and generate better returns in the long term. Before investing you need
to analyze your portfolio and mark all sectors to which you already have a
considerable exposure. A particular sector/stock can be added when you are sure
about the performance of the sector /stock but your portfolio lacks the same.
Now, investing in a particular sector/stock can also be done in two ways - direct
stock picking and sectoral mutual funds. Direct stock picking requires an in-depth
analysis and still would be a too risky bet. Against these, an advantage
through sectoral mutual funds would be diversification across stocks in that
particular sector with considerably lower amount of investment. This increases
the overall width in the portfolio even with limited amount of funds. Buying
individual stocks in a sector would neither be possible nor feasible but mutual
funds allow buying units with small amounts and in turn the investor gets
exposure to the diversified stock list of those particular sectors. Thus,
sector funds should be kept as an add-on to your existing portfolio. Moreover,
allocation to any particular sector should not go overweight in comparison to
other sectors.
Sector funds expose
your portfolio to concentrated risk, in fact, it can incur you a huge loss, if
you do not keep yourself abreast of business cycles. On the other hand, if you
are well-versed with the sector fundamentals and have the capability to assess
the volatility that is bound with such funds, you can make a good profit.
However, always be very careful when investing in sector funds and invest only
a limited portion of capital!
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