Should you invest in sector funds?

When Gurgaon-based software professional Varun Goel’s company bagged a couple of large contracts from Europe at the start of the year, it set him thinking. The rates offered for these contracts were higher than what the company had to settle for in 2012. What’s more, the rupee’s continuing weakness vis-avis the dollar made them even more lucrative.

And demand for IT services from the US market was also beginning to perk up. So Goel reckoned that it was a good time to invest in the technology sector. He consulted his financial planner and invested in a technology fund.

While Goel’s knowledge of the IT sector gives him an advantage, the average investor should exercise a lot of caution when betting on a sector-specific fund. The focused exposure can be rewarding if your research proves right. But the investment also carries greater risk because it is linked to the fortunes of a single sector.


Advantages of sector funds

Sector funds offer some obvious advantages to the investor. One, when the market advances, some sectors are at the forefront. In the past couple of years, for instance, sectors like banking and fast moving consumer goods (FMCG) have done well. If you had correctly predicted that these sectors would outperform and had made an extra allocation to them, your portfolio returns would have exceeded those generated by the broader market.

Two, an investor who is bullish on a particular sector may not know how to capitalise on his knowledge. Some time ago, an investor who tracks the power sector closely was bullish about the prospects of that sector.

His rationale: given the perpetual shortage of power in the country and the reforms taking place at state electricity boards, a bet on the power sector would yield handsome returns. However, he was not sure about which segment of the sector should he invest in—generation, transmission or equipment manufacturers.

He was also not sure which stocks to bet on. Finally, he invested in a power sector fund. Says Vishal Dhawan, chief financial planner at Mumbai-based Plan Ahead Wealth Advisors: “When you invest in a sector fund, you get access to the best stocks in that sector chosen by someone who tracks the sector closely.”

While sector funds belong to the top end of the risk spectrum, under certain circumstances they can help reduce portfolio risk. According to Saurabh Pant, fund manager, SBI FMCG Fund, “In a portfolio of multiple mutual funds, a sector fund can reduce portfolio risk provided the sector has a low correlation with the other equity funds and has low sensitivity to macro-economic factors.” The FMCG sector, he says, exhibits these characteristics.

Disadvantages and risks

Narrow mandate: Sector funds invest only in the chosen sector. They get hit hard if the sector is faced with adverse developments. Venkatesh Sanjeevi, fund manager, ICICI Prudential Banking and Financial Services Fund cites the example of banking sector funds. “When the economy slows down, banking sector funds suffer due to deterioration in asset quality (the number of unpaid loans rises),” he says.

Highly volatile: If you look at the performance of mutual funds in a particular year, the top performer is likely to be a sector fund. But the worst performer is also usually a sector fund. Moreover, the top performing sector changes every year. So, sector funds are highly vola-tile (see graphic).

Investing based on past returns: Often investors choose to go overweight on a sector when a rally is already over. The technology sector in 2000 and power and infrastructure sectors in 2007 witnessed investor frenzy when they were close to their peaks. Investors who enter at this point end up participating only in the downhill ride.

Loss aversion: Matters get compounded further due to investors’ tendency to hold on to a losing position because they are reluctant to book a loss. Says Dhawan: “If you discover that the sector faces problems that can’t be addressed in the short term, cut your losses and exit.” It’s best to set a downside target level at which you will jettison these high-risk investments.