FUND FLAVOUR

October 2018

Sector Mutual Funds…

Sector funds and thematic funds belong to the category of equity mutual funds. These funds are a stark contrast to diversified equity funds. Sector funds focus on specific sectors or industry like banking, pharmaceuticals, information technology, infrastructure, real estate, energy, etc. Thematic funds, on the other hand, invest in stocks which are well-defined around a particular opportunity. These might look similar to sector funds but may consist of several sectors. You may perceive these to be much more diversified than sector funds because they invest in a theme (sectors associated with the theme), e.g. a thematic consumption fund may invest in sectors as diverse as automobiles, consumer durables, FMCG, financial services, media etc.

… a market performer?

The market is an aggregation of all the sectors – over any given period of time, some sectors will outperform the market and some sectors will underperform. No sector has been able to beat Nifty consistently over the last 5 years. If you are investing in sectoral mutual funds, there will be years in which your fund will underperform and there will be years in which you will get blockbuster returns. You need to have high risk appetite for sectoral mutual funds. When evaluating sectoral mutual fund performances, you should compare your fund’s performance with the scheme benchmark (as mentioned in the Scheme Information Document or SID) and not with Sensex, Nifty or other broader market indices. You should not look at year on year returns in sectoral mutual funds – rather you should focus on point to point return over your investment tenor. The performance of your sectoral mutual fund will depend on the sector’s performance. Relative performances of different sectors depend on stages of investment cycles (bull market and bear market), economic conditions (interest rates, foreign exchange rates etc.), political developments etc. For example, cyclical sectors perform well in bull markets (e.g. banks outperformed in 2014 and 2017) while defensive sectors (e.g. Pharmaceuticals, FMCG etc.) tend to outperform cyclical sectors and the market in bear markets. In India, generally, share prices of banks rise when interest rates fall, however, the opposite is true in the US. Export oriented sectors will be hurt by INR appreciating versus USD, while domestic sectors may benefit from INR appreciation. Oil exploration companies will benefit from rise in crude oil prices, while refineries and companies which depend on oil imports will be hurt by rising crude prices. Some sectors like banks and pharmaceuticals are subject to regulatory risks – favourable regulation changes benefit these sectors while unfavorable ones hurt them. Sectors like infrastructure benefit from favourable Government policies and vice versa. Therefore, when you are investing in a sectoral mutual fund, you should be aware of risk factors associated with the sector and take an informed decision.

Arguments in favour…

If you invest your money in a sector that has high-growth potential, you will notice that the funds tend to increase substantially in price when the product demand is high. So, if the growth trend for that particular sector or theme predicts continual demand, then your investment is a good one.

It is true that different sectors outperform or underperform in different market conditions, but it is also true that over long investment tenures certain sectors have outperformed the market. Even in a matured market like the US, certain sectors have outperformed the S&P 500 over a 10 to 20 year period. In India certain sectors have outperformed not just the Nifty 50 but the broader Nifty 500, over a 10 year period. By investing in these sectors, through sectoral mutual funds, you could have got market beating returns. Timing is not all important in sector funds – sectoral mutual funds can be great long term investment options. If you have a medium term investment tenor like 3 to 5 years or so, then sectoral mutual funds can be risky but over very long tenors, sectoral mutual funds can enhance your portfolio returns.

…and against

While higher growth in the chosen sector represents good news for the investor, a downturn in the sector represents heavy losses. The reason behind this is the lack of diversification in holdings. Investing in a sector fund is equivalent to putting all of one’s eggs in one basket; if the basket were to fall, the eggs would all break. Thematic funds, although more diversified than sector funds, are also dependent entirely on one particular theme.

The most basic argument is that different sectors find favour in different market conditions. It is difficult for retail investors to guess, which sector will outperform in the near to medium term.

The other argument against sectoral mutual funds is that, retail mutual fund investors select funds mostly on the basis of past performance, i.e. they tend to invest in mutual funds which have given high returns in the last one or two years. This investment strategy may backfire with sectoral mutual funds because the sectors which gave high returns may quickly run out of steam and leave retail investors stranded. This can happen at bull market peaks like what happened with certain sectors in 2008 or when institutional investors rotate sectors by booking profits in stocks where they got high returns. Some sectors may go out of favour due to regulatory and political changes, which are outside the control of companies, e.g. pharmaceuticals over the last 2 years due to regulatory changes in the US. Overcoming regulatory challenges and changes in political scenario may take a long time.

The strongest argument against sectoral mutual funds is information or knowledge gap between the fund manager and an average retail investor. Fund managers of diversified equity mutual fund schemes are required to deliver alphas (higher returns than benchmark) and they do this by being over-weight / under-weight on sector allocations versus the benchmark and through stock selection.

Sector Mutual Funds – the caveats

If you believe that sector funds are the proverbial pot at the end of the rainbow in the mutual fund arena, then keep this in mind.

·    Like any other investment, you need to have clear financial goals for investing in sectoral mutual funds. You should not invest in sectoral mutual funds, simply because you have funds to invest and want to make a quick profit. Chasing quick profits in sectoral funds can burn your pocket, because timing can go horribly wrong with these funds.

·    Do not invest in sectoral mutual funds, simply based on last 1 year returns. You are likely to get disappointed, unless you have a very long investment tenor. If you have long investment tenors, then you should invest in sectors which are likely to play a critical role in India’s Growth Story. If you have a medium term investment tenor, then invest on the basis of 3 to 5 year outlook for the sector and consider risk factors before investing. Either way, you need to have knowledge of the sector before investing.

·       You need to have a high risk appetite. Some sector funds can underperform for a long time. You need to be patient for the sector to recover and your fund to deliver returns. You should allocate only your highest risk capital to sectoral mutual funds. Risk capital is the money, which you do not need to access for liquidity needs in the short to intermediate term – you should have sufficient capital in other investment options for your short to intermediate term liquidity needs.

·      You should have an absolute returns mindset when investing in sectoral mutual funds. You should not worry about year on year volatility. When you reach your target absolute returns, you should exit the investment. Do not worry about leaving money on the table because the returns may quickly fizzle out, if the sector goes out of favor in the market.

·      Diversified equity mutual funds should form the core of your investment portfolio. Sector funds can be good add-ons to your portfolio to enhance wealth creation.

·     Investment in equity mutual funds should be made with at least a 5 year horizon. Much can change within one sector which can lead to underperformance of a sectoral fund. Even a skilled fund manager will not be able to do much if restricted to a sector with significant headwinds and not allowed to switch to a sector with tailwinds. This is captured very well in Warren Buffet words, “Good jockeys will do well on good horses, but not on broken-down”

Are Sector Funds right for you?

You have heard that market timing rarely pays, but occasionally you would at least like the flexibility to be more tactical with your portfolio picks. Sector funds could be the tool to use, but are they worth the risk? The answer depends on how actively you follow the market and what you already own. You have to ask yourself why you want to buy into that particular sector, why you believe it is likely to outperform, and what your criteria are for getting rid of it. If you cannot answer those questions, you probably should not own it. Sectoral funds are meant for a sophisticated investor who can assess the structural movements in the particular sector. Sectoral funds are hyper sensitive to events such as government actions or regulatory changes. So, importance of timing the market is high. If you intend to invest in sectoral funds then you must study and research the sector well. Common man caveat emptor!