While it is generally suggested that market timing doesn’t work, it does so in case of sector funds. Recently we have observed the indirect promotion of sector funds in the mutual fund industry. A sector fund is a mutual fund that invests most or all of its assets in one specific sector or its allied industries. A list of sectors will usually include Technology, Financials, Health care, Consumption etc.
A sector fund invests at least 80% into equity and equity-related instruments of a particular sector. Currently, pharmaceuticals is a sector labelled as ‘beaten down’ and stocks in this sectors are supposedly available at attractive valuations.
Investors’ behavioural pattern suggest the flow of assets in the type of funds/stocks/securities that are more talked about. Therefore, this article aims to provide our readers with some food for thought.
It is important to note that the sector funds are not for every investor and there is no right way or wrong way to go about using them. So before buying into one you should understand the pros and cons.
Almost every financial guru in the world would agree to the fact that diversification is the best way to reduce risk in an investor’s portfolio. A well-diversified portfolio would be spread across asset classes having very low correlation to each other, thus ensuring downside protection. Similarly, within each asset class it is necessary to spread the investment across sectors, geographies and countries.
When it comes to equities Indian investors have a lot of choice in the sheer number of different categories of mutual funds available. Before we delve into the nuances, let us understand the context against which mutual fund portfolios are built.
All mutual funds in India are compared with their benchmarks for assessing their performance. A mutual fund consistently beating a benchmark is considered a good long term wealth creator. Broader benchmarks by their fundamental design consist of companies across different sectors. While some sectors have higher weight like Financials, Consumer goods etc some get relatively lower weight. A mutual fund manager hence will have to construct a portfolio that is more or less aligned with that benchmark constitution. He takes a few active calls and, in the process, tries to beat the benchmark. But the majority of the portfolio has a lot in common with the benchmark.
Hence, by default an investor in a normal mutual fund has his portfolio diversified across sectors. While this reduces risk, so does the possible return profile in the short term. To illustrate this let’s look at returns of a diversified index vs a sectoral index over the last one year. The returns of the broader Nifty 50 index is 5.52% while the Nifty Bank index is up 14.1%. An investor in a banking fund would have done better than a large cap fund investor. Does this mean you should invest in banking funds? The short answer, no.
All sectors go through cycles of growth and slowdown depending on the conditions of the economy both domestic as well as global. In case of the banking sector, it came out of the NPA problems in the last one year and also benefitted from the recent NBFC crisis which shifted focus back on corporate banks.
The IT sector benefits when there is global growth especially the developed countries like US, European countries. Consumption benefits from a growing economy and hence more disposable income in the hands of people to spend.
More recently Pharma funds are back in focus as the mutual fund industry is marketing the deep correction that happened in the sector over the last three years as an opportunity to invest at bottom and are advertising the possible turn in the tides for that industry.
By virtue of their cyclical nature the return profile of sector funds also follows the same path. Long time investors are well aware of Infrastructure funds and their spectacular rise and fall in performance pre and post global financial crisis. A similar story played out in Pharma funds between 2011-18. Investors in these funds who invested at the peak in 2015 are still not out of the woods.
Any investment in a sector fund is like a bet on the prospects of that sector and hence investors should take exposure to such funds only if they are informed and convinced of the sector’s growth trajectory. While it is generally suggested that market timing doesn’t work, it does so in case of sector funds. So yes, at what part of the business cycle you invest in a sector fund decides your return profile from that fund.
If you are a first time investor or have recently dipped your feet in the markets we recommend you continue with diversified funds before taking on more risk with sector funds. Sector funds are for reasonably informed, evolved investors.
If you do decide to invest keep following things in mind:
1. Use them as satellite part of your portfolio rather than the core
2. Have no more than 10-15% of the portfolio invested in sector funds
3. Invest Lump sum rather than SIP
4. Do not go by past returns or past record of the fund manager
5. Have exit criteria in place and adhere to it.
6. If the sector fund doubles up your money in the next one or two years book the profits. The probability of that fund performing the same in the year after that is next to zero
More often than not mutual funds launch sector funds or promote their existing ones when the sectors are doing well and are at their peak. Do not fall into the trap of this euphoria and do your due diligence before investing.