Should you invest in Sectoral Mutual Funds

There are several views with regards to investing in sectoral mutual funds. Some financial advisors are of the opinion that sectoral mutual funds are too risky for average investors; sectoral mutual funds have sector specific risks associated with them and are therefore, riskier than diversified equity mutual funds. On the other hand, some advisors have commented on our website that they have recommended sectoral funds to their clients and these funds have enhanced the investor’s portfolio performance.

Some mutual fund experts say that timing of investment and exit is critical for sectoral mutual funds. However, if you look at 10 year returns of some sectoral funds their performance is at par or even exceeds top quartile multi-cap equity mutual funds – these sectoral mutual funds can therefore, be good long term investment options. There are conflicting views on sectoral funds and there is no simple answer whether sectoral funds are right for you or not. In this blog post, we will discuss about sector funds, risk factors and pros / cons of investing in these funds. We will also discuss guidelines for investing in sectoral mutual funds.

What are Sectoral Mutual Funds

As opposed to multi-cap equity funds which invest across different sectors, sector funds invest in a particular industry sector. Therefore, sectoral mutual funds are subject to sector risks along with market risks, while multi-cap equity mutual funds are subject mostly to market risks. My point of dissonance with sectoral mutual fund detractors is about the over-simplification of risk in the multi-cap equity mutual funds versus sectoral mutual funds narrative. It is true that sectoral mutual funds are generally more risky than multi-cap equity funds, but it also true that different categories of multi-cap equity funds have different risk profiles, e.g. midcap and small cap funds are more risky than large cap funds. Will sectoral mutual fund detractors also advise investors to avoid midcap mutual funds? Surely not, I hope. We need to understand the nature of risk; more on that later.

There are mainly four different types of sectoral funds:-

• Banking and Financial Services


• Infrastructure


• Technology


• Pharmaceuticals and Healthcare

In addition to these sector funds, there are thematic funds which are more diversified than sectoral mutual funds because they invest in a theme (sectors associated with the theme), e.g. a thematic consumption fund may invest in sectors as diverse as automobiles, consumer durables, FMCG, financial services, media etc. There are different types of thematic funds. As per SEBI’s scheme categorization directive, Asset Management Companies (AMCs) have categorized their thematic mutual funds based on the theme, e.g. energy, MNC, PSU etc. In the rest of the post, our discussion will be centered on sectoral mutual funds.

Different sectors outperform / underperform the market at different times

The market is an aggregation of all the sectors– over any given period of time, some sectors will outperform the market and some sectors will underperform. The chart below shows the annual performance of the market index, Nifty 50 TRI versus different sector indices.

Source: Advisorkhoj Research, NSE

You can see that no sector was able to beat Nifty consistently over the last 5 years. If you are investing in sectoral mutual funds, there will be years in which your fund will underperform and there will be years in which you will get blockbuster returns. You need to have high risk appetite for sectoral mutual funds. When evaluating sectoral mutual fund performances, you should compare your fund’s performance with the scheme benchmark (as mentioned in the Scheme Information Document or SID) and not with Sensex, Nifty or other broader market indices. You should not look at year on year returns in sectoral mutual funds – rather you should focus on point to point return over your investment tenor.

Factors which affect Sectoral Mutual Fund performance

The performance of your sectoral mutual fund will depend on the sector’s performance. Relative performances of different sectors depend on stages of investment cycles (bull market and bear market), economic conditions (interest rates, foreign exchange rates etc.), political developments etc. For example, cyclical sectors perform well in bull markets (e.g. banks outperformed in 2014 and 2017) while defensive sectors (e.g. Pharmaceuticals, FMCG etc.) tend to outperform cyclical sectors and the market in bear markets. In India, generally, share prices of banks rise when interest rates fall, however, the opposite is true in the US.

Export oriented sectors will be hurt by INR appreciating versus USD, while domestic sectors may benefit from INR appreciation. Oil exploration companies will benefit from rise in crude oil prices, while refineries and companies which depend on oil imports will be hurt by rising crude prices. Some sectors like banks and pharmaceuticals are subject to regulatory risks – favorable regulation changes benefit these sectors while unfavorable ones hurt them. Sectors like infrastructure benefit from favorable Government policies and vice versa. Therefore, when you are investing in a sectoral mutual fund, you should be aware of risk factors associated with the sector and take an informed decision. Investing in sectoral mutual funds is certainly not as simple as investing in multi-cap equity funds, which begs the question, is it worthwhile investing in sectoral mutual funds. In Advisorkhoj, we are not biased towards or against any investment – we will try to give you a rational view of both sides of the debate.

Arguments against Sectoral Mutual funds

The most basic argument is that different sectors find favor in different market conditions. It is difficult for retail investors to guess, which sector will outperform in the near to medium term. The other argument against sectoral mutual funds is that, retail mutual fund investors select funds mostly on the basis of past performance, i.e. they tend to invest in mutual funds which have given high returns in the last one or two years.

This investment strategy may backfire with sectoral mutual funds because the sectors which gave high returns may quickly run out of steam and leave retail investors stranded. This can happen at bull market peaks like what happened with certain sectors in 2008 or when institutional investors rotate sectors by booking profits in stocks where they got high returns. Some sectors may go out of favor due to regulatory and political changes, which are outside the companies control, e.g. pharmaceuticals over the last 2 years due to regulatory changes in the US. Overcoming regulatory challenges and changes in political scenario may take a long time.

The strongest argument against sectoral 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?

Arguments in favor of Sectoral Mutual Funds

It is true that different sectors outperform or underperform in different market conditions, but it is also true that over long investment tenures certain sectors have outperformed the market. Even in a matured market like the US, certain sectors have outperformed the S&P 500 over a 10 to 20 year period. In India certain sectors have outperformed not just the Nifty 50 but the broader Nifty 500, over a 10 years period – please see the chart below. By investing in these sectors, through sectoral mutual funds, you could have got market beating returns.

Source: Advisorkhoj Research

There were other sectors which outperformed the Nifty, but we showed sectors related to which there are sectoral mutual fund schemes. Some may argue that, top performing multi cap equity mutual funds have given similar if not better returns. The counter argument is that how will investors know which will be the top performing mutual fund in the next 10 years? Many of the funds which were top performers 10 years back are no longer top performers. When comparing categories or sectors in mutual funds we can only compare averages. The chart below compares 10 year trailing average returns of select sector and multi cap equity mutual fund categories.

Source: Advisorkhoj Research

You can see that, the select sector funds were the best performers over a 10 year period. These sector mutual funds outperformed most equity mutual fund categories, e.g. multicap, large and midcap, large cap, except small cap and midcap funds. As discussed earlier, small and midcap mutual funds are among the riskiest diversified equity funds categories – it is all about risk and return, as far as investments are concerned. The chart above conclusively disproves one notion that, timing is all important in sector funds – it is not; sectoral mutual funds can be great long term investment options. If you have a medium term investment tenor like 3 to 5 years or so, then sectoral mutual funds can be risky but over very long tenors, sectoral mutual funds can enhance your portfolio returns.

How to invest in Sectoral Mutual funds

Here are some guidelines:-

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


• Do not invest in sectoral mutual funds, simply based on last 1 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 sectoral mutual funds. I define risk capital as 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 sectoral 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.


• Some financial planning experts suggest that for the purpose of risk diversification, you should not invest in a sector where you are working. They say that if the sector does well, you will gain in financial terms both through higher salary / bonuses and through investment gains, but if the sector does poorly, then you stand to lose on both grounds. There may be some justification in such a view, but in my opinion, among all sectors, you will be the most knowledgeable about the sector where you are working. Therefore, you will be able to take an informed decision, whether you want to invest in the sector you are working or not.


• In our view, 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. You may like to read – diversification and how to take advantage of it
  
  If you have a medium term investment tenor, then timing is very important in sector funds, which means that you should enter these mutual funds when they are recovering from their lows and exit when they are at a high or when you have achieved your goals. However, if you have a long investment tenor then timing does not matter.

Conclusion

In this blog post, we have discussed about sectoral mutual funds. You should consult with your financial advisor, if sectoral mutual funds are suitable for your investment needs.