FUND FLAVOUR

August 2021

Sectoral Mutual Funds…

Sectoral funds are equity funds that concentrate their portfolio towards equities of companies across all market capitalizations of a particular sector. These funds invest only in businesses that operate in a particular sector or industry. For instance, a sector fund may invest in sectors like Banking, Pharma, Construction, or FMCG sectors, among many others. According to the guidelines laid down by SEBI, sectoral funds are bound to invest a minimum of 80% of their assets in the specified sectors. The remaining 20% can be allocated to other debt or hybrid securities. On the other hand, thematic funds are the ones that invest in stocks based on a particular theme. The theme chosen by such funds may revolve around areas such as rural consumption, commodity, defense, etc. For instance, a thematic fund may focus on rural consumption and invest in funds of all sectors that favour this theme. The major difference between both these funds is that sectoral funds invest in only one sector, whereas thematic funds invest across multiple sectors that are woven around a common theme.

 

Rise with the tide…

The advantage of investing in sector funds is that if a sector is performing exceptionally well, there is a chance to book inflation-beating profits but that is contingent on investors being able to hit the bull’s eye when entering and exiting the market, especially if the investment is short-term. This is because sectors are cyclical in nature and they may not always be aligned with. Sectoral funds tend to offer potentially high returns if chosen correctly. Sector funds are an excellent investment option for long-term financial requirements.

A risky proposition…

Since sector funds are a class of equity mutual funds, they essentially carry concentration, volatility and liquidity risks. Since these funds invest heavily in equities of a specific sector, they carry a high risk of concentration. Sector funds are generally categorized under the riskiest class of mutual funds. High-risk investments come with high return potential. The market fluctuations and the resultant volatility risk have a direct influence on these funds. If the sector is performing well, then the fund may provide excellent returns. On the other hand, if the sector fares poorly, the losses may be magnified.  Liquidity risk is the probability of the fund manager being in a position wherein he fails to sell the underlying securities. Since a sectoral fund is launched for a specific sector, the risk increases because of concentrated investments. In accordance with SEBI regulations, sector funds have to invest at least 80 per cent of their assets in their mandated sector. Hence, their fund managers cannot exit the mandated sectors even if they are convinced of its prolonged underperformance due to business cycles, government regulations or other factors. Returns generated by sector funds primarily depend on the performance of the respective sector, which these funds are mandated to invest in. This leads to higher risk for sector funds compared to the sector agnostic diversified equity funds.

 

Apt for…

Sector funds are suitable for aggressive investors or those willing to take higher levels of risk in exchange for the potential to earn overwhelming returns. The risk of concentration of these funds is on the higher side since these funds invest in equities of a particular sector. Generally, sector funds are best suited to investors who already own diversified funds in their core allocations, and want an opportunistic investment in the sector. These also appeal to institutional investors who want focused exposure to a particular sector, and would rather own a basket of companies in the sector rather than identifying individual businesses within the sector. If an investor's portfolio lacks exposure in a specific sector, then the sector funds can be an option to invest in the sector in a diversified manner. Investors must understand how the companies of the sector they are choosing to invest, go about their business. If not, it is not advisable to invest in these funds.

 

Criteria to be considered

• Investors have to be aware of and ensure the following before they invest in a sector fund:
• ·         Sector funds carry higher levels of risk and they must be willing to assume this risk.
• They have to ensure that their investment objectives are in line with the objectives of the fund.
• Sector funds may require them to carefully analyze and assess the market conditions before investing in a sector fund.
• While investing, they must keep their portfolio diversified across multiple large cap and mid cap funds, along with sectoral and thematic funds.
• Since both these funds depend on the performance of sectors (individually or otherwise), there are high chances that their portfolio will face fluctuations in both, bullish and bearish markets.
• Investments in sectoral and thematic funds are clearly suitable only for investors who are active and have a clear understanding of the market and macroeconomic conditions.
• Being cyclical in nature, they must carefully keep a check on the entry and exit timing of sectoral funds.
• The suggested investment horizon for these funds is more than 5 years; if the investors redeem their investment before that, it is much likely that they would not receive positive results
• While investing in these funds, investors must consider the future growth opportunities in that sector and then make a choice, rather than looking at the past performance of the fund and/or sector
• Investors should not invest more than 5-10% of their funds in such schemes, considering the volatility of sectoral funds
• Before investing in sector or thematic funds, investors should check the earnings of the sector and whether the theme is sustainable. There is no point plunging into these investments if the sector is not making progress or if the theme is just a fad.
• Investors should estimate their expense ratio before investing. Asset Management Companies (AMCs) charge an annual fee for managing funds. This covers the fund’s operating and other expenses. It is better to avoid investing in funds where the expense ratio can eat into their returns.

 

Performance

Given that most sectoral and thematic funds, particularly those belonging to technology and healthcare sectors, have outperformed the broader market (S&P BSE 500) by a fair margin since the lows of March 2020, such funds are gaining traction from mutual fund investors. Sectoral funds have on an average delivered 86.5% returns in the last 1 year. Their 3 and 5 year returns are 31.99% and 26.78%. The net assets under management of sectoral/thematic funds rose 79% to Rs 1.1 lakh crore in April 2021 from Rs. 56,800 crores in April 2020 as investors typically tend to chase recent performance. After the outbreak of Covid-19 early last year, the stock markets witnessed significant drawdowns of around 40% on concerns over the economic impact. However, after announcements of massive fiscal and monetary stimulus across the globe, followed by optimism around vaccine discovery and roll-outs, equity markets bounced back sharply. Sectors like pharma, information technology, banking, etc., continue to draw the attention of investors. With the economy poised for a recovery having contracted 7.3% in FY21, cyclical sectors such as financials, industrials and basic materials are likely to do well as the economic recovery picks up steam. However, given the uncertainty around the pandemic, it is best to stick to long-term asset allocation and invest the core of the portfolio into well-diversified funds avoiding excess concentration in a single sector/theme.

 

The bottomline…

Sectoral funds are not bad per se. But they are not suitable for most investors. Hence, it is best to avoid investing in sector funds when building long-term portfolio. These fund can really end up making a huge profit, if the timing of investment is accurate. Investors should know when to enter and exit the fund. Investors should invest in areas of the market where they are confident about or see growth in the future. The main idea is to tap-in on the growth of a particular industry and sector. Moreover, sector funds have the ability to protect investors from individual firm-specific risk. Rather than buying individual stocks, investing in sector funds would ensure that a company’s bad performance would not affect their portfolio. But, before investing in a sector mutual fund, they should be confident on why they believe that sector is likely to perform well in the near future. Since Sectoral Mutual Funds are equity funds i.e. they invest in stocks of companies, investors need to stay invested for at least 5 years. Sectoral Mutual Funds invest in equities, so in the short term, they can be volatile. However, over the long-term, the risk comes down substantially.