Mutual Funds

Sector funds are not everyone’s cup of tea

Anand Kalyanaraman | Updated on November 19, 2014

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They entail high risk. You must know sectors and their cycles well to benefit from them.



Are sector funds a good long-term investment avenue?

Not quite. Sector funds are not everyone’s cup of tea — they entail high risk; require expert knowledge of the sector, and a strong ability to time the market.

Unlike diversified equity funds which hold stocks across sectors, pure sector funds invest predominantly in stocks of particular sectors. So, an IT fund may hold mostly software stocks, an energy fund may have high exposure to energy stocks, and so on.

Now, this can be a double-edged sword. When the sector is doing well and is in the investors’ good books, sector funds can be out-performers, as is the case currently with pharma and IT funds.

But when the tide turns, sector funds can be among the big losers. When a sector starts slipping on performance and falls out of favour, funds focussed on it suffer sharper cuts than the broader market — a current case in point being energy funds which have done rather badly over the last one-, three-and five-year periods.

This is because the portfolios of sector funds are concentrated in a limited number of homogenous stocks. This ‘all eggs in one basket’ of sorts approach makes these funds a high-risk bet.

Returns vs risk

Does high risk guarantee high returns?

Not really. You must know well enough about the sector and its cycles to benefit from such funds. Every sector goes through peaks and troughs, which reflect in the performance of its stocks.

The ‘buy-low and sell-high’ mantra for investment success requires that you be able to time your entry into the sector fund when the stocks are at a trough, and exit when they are at their peak. The trouble here is, even experts can and often do go wrong on their calls regarding the timing and length of sector cycles.

Sector funds could also suffer from lack of flexibility and may be left holding the can. Being mandated to hold predominantly stocks of the sector, these funds may not be able to completely exit when the going gets tough, or to capitalise on good buying opportunities in other sectors.

Ergo, sector funds may not be suitable for those who seek consistent returns and want to build a long-term portfolio.

Safety in numbers

How can one play the opportunity in specific themes? It could be a vehicle to participate in the up-cycles of specific sectors. But as mentioned, this too requires good knowledge of the sector and knowing when to enter and exit.

If you know well about a sector and its cycles, and are optimistic about some stocks in the group, you may be better off picking and choosing those stocks, rather than going for a sector fund.

Investing through a well-managed diversified equity fund is also a good option for those seeking to play opportunities in specific sectors. These funds, with the flexibility to shift among sectors and stocks, possess the nimbleness to capitalise on emerging opportunities and also to cut losses when needed.

By spreading their eggs across many baskets, diversified equity funds reduce risks even as they retain the ability to make good returns — which is where they score over sector funds.

Published on March 02, 2014

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