FUND FLAVOUR

October 2019

The high-risk high return rendezvous

In the world of investing, there are investors who firmly believe in ‘High-risk High-return’ investments. For such high-risk takers, mutual funds have something on hold – Sector Funds!

Sector funds…

Sector funds are mutual funds that invest their assets in a particular sector, such as infrastructure, technology, pharmaceuticals, real estate, banking, etc. These funds predominantly invest in equities of companies from a particular sector. Since these funds, invest in one specific market segment, they tend to be risky. As per the guidelines issued by the Securities and Exchange Board of India (SEBI), a sector mutual fund has to invest at least 80% of its assets in equity or equity-related instruments of the selected sector. Sector mutual funds aim to take advantage of the market situation by investing in those fields which have the highest potential for growth or are already the fastest expanding sectors of the country. The best sector funds have a portfolio of companies that operate in the same industry. This boosts the expansion of the respective sector, thereby generating higher profit levels, leading to higher returns on such investments.

Thematic funds…

Thematic funds are mutual funds that invest in a theme-oriented pattern that may comprise of multiple sectors. For instance, a particular thematic fund may invest in energy oriented industries. This would include MNCs operating in the energy sector, Solar Power Plants, etc. As per SEBI guidelines, for a fund to be classified as a thematic fund, it must invest at least 80% of its assets in the sectors related to a particular theme. Rest of the assets can be allocated to other equity, debt or money market instruments.

Thematic funds offer more diversification than sector funds. The former bet on a particular theme and capitalize on the good performance of the companies operating under that theme. Even if one sector of the theme does not perform up to the mark, the fund still manages to contain losses with high diversification. Sector funds invest only in companies of a particular sector, which exposes them to losses during unfavourable market fluctuations in that particular segment.

 

The pros…

Sector mutual funds offer high returns on investment when there is hope for a market boom for that particular sector. If an investor does a thorough research and invests in a sector/thematic after proper analysis of the market scenario, he/she may get high returns on investment. A mutual fund can exploit this untapped potential and extract huge dividend returns. These funds are ideal for individuals looking for a long term investment strategy which will yield beneficial results. Since these funds are optimal for a longer investment regime, benefits are not usually visible in the short term.

… and the cons

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.

Sector funds tend to be highly risky. When one sector observes an economic slowdown, all the companies from that sector are affected with loss in revenue. At times like these, mutual funds investing in that sector deliver losses. For instance, recently the automobile sector in India witnessed the worst crisis in the past 20 years. Funds which had allocated significant resources to this sector saw a sharp drop in their returns. UTI Transportation and Logistics Fund, which is a sector fund, saw losses above 30% in a single year. One can invest via Systematic Investment Plan (SIP) in these mutual fund schemes to mitigate the market risk to some level.

High volatility makes these funds very unpredictable as some sectors may do exceptionally well in a particular year and fall flat in the succeeding year or the vice versa.

The strongest argument against sector mutual funds is information or knowledge gap between the fund manager and an average retail investor or his / her financial advisor. Fund managers of Multi-cap 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. If a fund manager thinks that a sector is likely to outperform the market in the medium to long term, he or she is likely to be over-weight on the sector. Who is more likely to guess which sector will outperform in the future – the fund manager of a multi-cap equity mutual fund scheme or the investor? The fund manager has a huge knowledge advantage over the investor or his / her financial advisor through access to information, experience and knowledge of investing. Fund managers are also likely to rotate sectors more effectively than retail investors. Is it, therefore, not more prudent for investors to invest in multi-cap equity mutual funds and let fund managers make sector allocation decisions on behalf of the investors?

 

Performance

There are a total of 54 sector funds in the market among which five were launched last year. Out of the 40 asset management companies (AMCs) in the industry, 25 offer such funds. They are different from general mutual fund schemes that have their portfolio diversified across different sectors of the economy. For example, ICICI Prudential Technology Fund invests only in shares of technology-oriented companies such as Infosys Ltd, Tech Mahindra Ltd and Oracle Financial Services Software Ltd. Sector funds are not very different from diversified equity funds, when it comes to the cost of investing in them. They might be slightly expensive because the funds are narrower and have smaller economies of scale. Sector funds are likely to be expensive by anywhere between 0.25% and 0.5% annualised. The performance of sector funds is cyclical in nature and dependent on the individual sector’s performance. The infrastructure sector did well in 2017, with average returns of more than 50% while the returns in 2018 were around 20 to 25%. Similarly, banking stocks did well in 2017 but rising non-performing assets (NPAs) and reported scams did not help the sector in 2018. The IT sector on the other hand has been doing well for a couple of years because of the depreciating rupee. Most sectors are dealing with their own set of issues. That is why most of them are performing dismally. Most sector mutual fund schemes have offered negative returns this year. Infrastructure category is the worst hit, with -30.17 per cent returns since January 1. Energy and power category followed with an average CAGR of -26.32 per cent, pharma and healthcare with -15.25 per cent, consumption (-7.24 per cent) and banking (-1.77 per cent). The only exception was the technology sector, which has offered a CAGR of 43.87 per cent in the same time period.

Points to ponder…

There are certain aspects to consider before investing in sector/thematic funds. Sector/thematic mutual funds are a high-risk investment instruments. Therefore, it becomes imperative to choose a proficient and experienced fund manager while investing in these funds. Investors should remain cautious and should conduct in depth fundamental analysis before investing.

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

·         Do not invest in sector mutual funds, simply based on last one 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 or your financial advisor needs 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 sector 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 sector 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.

·         Multi cap equity mutual funds should form the core of your investment portfolio. For your primary long term life goals, multi cap equity mutual funds should be the primary investment choices. Sector funds can be good add-ons, to your portfolio to enhance wealth creation.

If you are a highly aggressive investor you can think of investing in these funds. You should limit exposure to these funds up to 10% and invest only those funds which compliment your current portfolio.

Before making an investment in the sectoral fund, you should ask the following questions.

§  Is the sector where you are investing undervalued or not? – There is no point in investing in the overvalued sector.

§  What are the triggers that will help in boosting the performance of the sector? – If you do not find two-three trigger points you should not invest in that sector.

§  How long will you keep your investment? – You should estimate the time period up to which the sector will continue flourishing.

§  What will be your allocation in the specific sector?

§  How much money you can risk and what will be your exit strategy?

If you have sure shot answers to the above questions, you can opt for thematic or sector mutual funds for investment.

The bottomline…

Sector funds are appropriate for aggressive investors seeking exposure within either an entire sector of the economy or a specific sub-section,  thereof. Overexposure to any given sector of the market can subject investors to undue risk and volatility, and appropriate measures should be taken to avoid this. Sector funds are funds that are really meant for active well-informed investors who often analyse the macroeconomic situation of sectors. The prime reason for investing in sector funds is to beat the market returns as they have high risk-reward ratio. So, when well-informed investors feel that this sector would be the future for the next couple of years then buying sector funds would help them in beating the diversified fund returns. For example, when dollar rates are high this would aid IT industry as this would help to boost their overall margin through forex gains. If their view fails it could adversely dent the portfolio. Hence, sector funds should not be used as main part of portfolio. If you are new to equity mutual fund investing these funds may not be your cup of tea.