FUND FLAVOUR

July 2020

In the world of investing, there are investors who firmly believe in ‘High-risk High-return’ investments. And for such high-risk takers, mutual funds have something to offer – Sector Funds! Sector Mutual funds invest in a particular sector as defined by their investment objective. A sector fund is a type of mutual fund that invests in securities of specific sectors of the economy, such as banking, telecom, FMCG, pharmaceutical, Information Technology (IT), and infrastructure. In other words, sector funds narrow down your invested wealth only to the specific industry or sector. For instance, a banking sector fund can invest a minimum of 80% of total assets in stocks of banking companies. The overall objective of such investment is to invest in those sectors which have a high growth potential in the near future. The main idea is to tap-in on the growth of a particular industry and sector. Such mutual funds can double or treble your money and investors with a high-risk appetite can invest in sector funds. These funds can really end up making a huge profit, if the timing of investment is accurate. Rather than buying individual stocks, investing in sector funds would ensure that a company’s bad performance would not affect your portfolio. Sector funds exhibit the ability to protect you from individual firm-specific risk. But, before you invest in a sector mutual fund, you should be confident on why you believe that sector is likely to perform well in the near future.

Sectors and themes to bet on…

Sectoral mutual funds or mutual fund schemes that invest in specific sectors or themes are recommended only to highly informed investors. These schemes are notorious for going through highly-rewarding phases, followed by prolonged rough patches. Government has been spending a lot of money on infrastructure and it will continue to do so for next few years. Apart from the infrastructure schemes, IT, pharma and FMCG schemes may also deliver good returns. IT and Pharma are more of contra play, simply because Pharma has been undervalued and IT was reasonably valued over the last couple of years. Pharma sector, which was facing trouble from US FDA, is poised to bounce back. Similarly, the IT sector has been underperforming because of the global slowdown. The IT sector has lot of companies which are very strong with sound products and services. So a good IT sector fund can give you moderate returns over next 2 to 3 years. Public sector enterprise (PSE) is another segment that was beaten down by stock market players till now and has started reviving only recently. Despite its recent outperformance, experts continue to remain bullish on banking and financial services sector since the banking sector is mostly out of the NPA problems and earnings revival is expected. First, ensure the sector is undervalued. Two, the sector should have certain triggers in the next one to two years that will lead to the broader growth of the sector. Unless you are convinced of these two things, you should not look at sectoral funds.

…a roller coaster ride

Many of the equity mutual fund schemes have either given low returns or negative returns in the last one year. However, sector mutual fund schemes are performing well and gave upto 28.3% in the last 1 year, 11.8% in the last 3 years and 17.7% in the last 5 years. Banking and Finance sector returned 14.8%, 6.9 % and 8.7% in the last 1, 3 and 5 years respectively. FMCG sector returned 28.3%, 11.8 % and 17.4% in the last 1, 3 and 5 years respectively. Infrastructure sector returned 21.6%, 11.4 % and 17.7% in the last 1, 3 and 5 years respectively. Technology sector returned 25.7%, 4.6 % and 14.4% in the last 1, 3 and 5 years respectively. Chart topping performance (12.8%) by energy funds during the past five years is mostly because of the rally in Reliance Industries.

Historical Returns – a recipe for disaster

Retail investor interest in thematic and sector funds have been increasing as some of these have generated good historical returns. Chasing historical returns is a recipe for disaster. The retail investors who chased high historical returns in mid- and small-cap schemes and invested in them during 2017-18 are still licking their wounds. This problem gets aggravated in concentrated bets like sector and thematic funds. For example, investors who were lured to invest in IT funds in 2000 or infrastructure funds during 2007 lost heavily. One way to avoid getting enticed by historical good performances is to look at funds at the bottom of the performance list. For example, international equity funds that generated the maximum returns (18.02%) during the past one year, generated only 5.26% CAGR—the lowest category average returns—for the 10-year holding period whereas MNC Funds generated 15.54% in the past 10 years. So what is the reason for the erractic performance of sector and thematic funds? Most sector funds will be at extreme ends because they carry higher concentration risk. The market performance we get is the average of several sector performances.

Points for retrospection…

Investment horizon

You should consider an investment horizon of at least five years while investing in sectoral funds.

Selection of sector and entry exit

The selection of the sector is of paramount importance while investing in these types of funds. Refrain from investing in a sector which is overvalued. Besides, careful selection of entry and exit points is absolutely essential.

Track portfolio

Tracking portfolio is essential when you are making an investment in sector funds. You should invest time to review the portfolio and related news about the sector, bearing in mind the fact that every sector goes through a cyclical phase of rising and falling in the specific investment horizon.

Limit on exposure

If you are an evolved investor and want to invest in sector and thematic funds, the next question will be how much money you should park in these. This can be a difficult question because each investor gets in with different objectives. So, let us answer this question considering one objective at a time.The first set of investors get into thematic funds for diversification and investment into international funds is a good example of that. Once investors are through with diversified domestic equity funds, they should look at global equity funds before looking at other thematic funds. Since this is a broader diversification strategy, all investors with sizable domestic exposure should go for it. Ideally, investors can park around 10%-20% of their equity in international funds. The next set of investors gets into this space for enhanced returns. The commonly followed strategy is to have a ‘core portfolio’ of diversified equity funds and then enhance the portfolio returns by investing in ‘hot sectors’. This strategy is followed by investors with high risk-taking ability. Only evolved investors should try investing through sector funds and they also must restrict this exposure to 10% of their portfolio since the performance of these funds is not guaranteed and the chance of gaining and losing money both is high. Besides, they should make sure that the new sector they are adding is not already heavy in their portfolio. Sectoral funds are generally more volatile than diversified indices or mutual funds with a variable performance from period to period. While most retail investors can safely avoid such funds, those interested could toy with these funds with their satellite portfolio after fully appreciating risks.

…to keep lay investors at bay

Since investing in sector funds requires a keen understanding of sectoral cycles, first-time investors are advised to avoid them altogether. Investing in sector and thematic funds involves some amount of timing strategy—both for entry and exit. Therefore, they are meant only for evolved investors. It is better all investors, except those who have special knowledge about that sector, avoid sector funds. Sectoral knowledge comes with tracking a sector closely for years or from working in that sector. However, investors should also make sure that their ‘bias’ about a particular sector does not impact their investment decisions. Though sector professionals have an edge in terms of better knowledge, they will also fail if they are not able to control their bias.

Patience and understanding cycles pays in the long run…

Since sectoral or thematic funds come with higher risks, investments in these must be done only in accordance with the advice of experts or if the investors are experts themselves in understanding stocks and stock markets. Some of the sectors are cyclical and hence understanding these cycles becomes important as well. These business cycles can be short or long, depending on the specific sector. As timing of these investments and redemption plays a very important role in the returns being generated by such funds, a lot more careful analysis and planning is required before investing. One can also adopt different strategies with these funds, some for long-term growth (sunrise sectors/themes), some for medium-term tactical gains (cyclical/beaten down sectors) and some for defensive strategies. However, it is not advisable to allocate more than 10 to 20% of your investments to these funds. This 10 to 20% could be divided among two-three sectors or themes. You must remember that your other mutual fund holdings may also have some allocation to these sectors. Making large allocations to these funds can be risky and should be avoided by retail investors. Also, there are some sectors or themes that are coming in vogue or their business cycles are on their way up. These cycles can fully play out and reach their peaks in the medium term (three to five years) or can take even longer. Hence, not just knowledge of these cycles but also patience in allowing the cycles to fully play out is important.