Should you invest in Thematic, Sectoral Funds?

Here are a few pointers to guide whether you should invest in Thematic, Sectoral Funds or not:

Should you invest in Sectoral Funds?

Sectoral/Thematic funds have been much-talked havens among the investors. But looking at the roller-coaster returns, you might keep deferring your decision.

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You may wonder whether it’s right to invest in sectoral funds or not?

Investors have created enormous wealth out of these funds, but there are lot many who lost everything in sectoral funds.

To be on the right side of investing, you need to have an in-depth understanding of sectoral funds.

Sectoral funds invest in a particular sector or industry. The returns of sectoral funds are affected by the industry performance.

When the sector is performing well, these funds may give higher returns than the benchmark. Sometimes, it might happen that all the stocks are falling, but sectoral funds stay buoyant.

However, you need to know the other side of the story as well.

During poor sector performance, sectoral funds may generate negative returns. There have been times when the entire market is rising, but the sectoral funds are treading south.

As compared to a diversified equity fund, the investment mandate of sectoral funds requires these to concentrate their allocation in the particular sector. You may find lesser diversification into other asset classes.

Such type of funds is commonly recommended to a highly aggressive investor.

In India, sectoral funds are confined to limited sectors. Commonly found sector-specific funds are as follows:

1. Pharma funds: these mutual funds invest in stocks of pharmaceutical companies.

2. Banking funds: these mutual funds invest in stocks of different banks.

3. Technology funds: these mutual funds maintain a portfolio comprising of IT companies.

4. FMCG funds: these mutual funds invest in stocks of fast moving consumer goods companies.

5. Infrastructure funds: these mutual funds invest in stocks of companies which benefit from the growth of infrastructure like metals, energy, construction, etc.

Sectoral funds can be highly risky bets; unless you are really sure of what you are buying. But that should not deter you from taking the call.

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Before investing in sectoral funds, ask yourself 4 questions:

– Why is the sector going to outperform?
– How long do I plan to stay invested?
– How much would I allocate to this sector?
– What is going to be the exit strategy?

In case you have got a definite answer to all of these questions, only then approach sectoral funds. Otherwise, don’t even think of entering these.

Risks involved in Sectoral Funds

Sectoral funds suffer from a variety of risks. Being a type of equity fund, market risk always influences sectoral fund returns.

Apart from that, one peculiar risk which sectoral funds undergo is the Concentration Risk. When you analyze the portfolio holdings of sectoral funds, you will find them concentrated in a particular sector.

A pharma fund would seldom allocate your money in something other than pharma stocks. Within the sectoral fund, there is lack of sector-specific diversification which you may find in multi-cap funds.

It has got implications. If the sector doesn’t perform well, the sectoral fund returns may suffer. In case your portfolio is only composed of a sectoral fund, then your entire investment may suffer.

Things to remember while investing in Sectoral Funds

1. Efficient diversification

You can have varied perspective while getting into investments. Sectoral funds are known to give extraordinary returns vis-a-vis other broad-based funds.

For instance- considering a 5-year horizon, ICICI Prudential Banking & Financial Services fund gave a return of 23.85% compared to ICICI Prudential Value Discovery Fund which gave 20.42%. The former is a sectoral fund while the latter is a multi-cap fund.

Hence, sectoral funds can be a prudent way to make money. If you have a core portfolio consisting of diversified equity funds, then you can add a zing to it. Add a few sectoral funds to earn returns over and above the regular multi-cap funds.

But remember while your returns might increase, it will impact the portfolio risk profile as well. Your portfolio’s risk may increase considerably upon such an addition.

2. Portfolio Hedging

Hedging refers to reducing the risk inherent in a portfolio. Although riskier than diversified equity funds, sectoral funds can become a useful hedging instrument.

It will help to keep the portfolio returns in line with your expectations. Consider a situation when the entire market is trending southwards. In such a case, sectoral funds would act as a cushion for the portfolio.

You know that inflation driven by high prices of petrol bring the entire economy down. But it can be a boon for companies present in the energy sector.

So, a portfolio comprising of multi-cap funds may still yield decent returns. You just need to hold a certain portion of energy funds in that to keep the party going.

3. Limiting the exposure

One point needs to be kept in mind while investing in sectoral funds, i.e., there are no permanent winners.

If a sector performed consistently well for a couple of years, it doesn’t guarantee that the good performance will be there forever.

Let’s understand this with an example.

The table below gives an overview of the performance of sectoral funds across time horizons. You may notice that the top performer varies for each time horizon.

Should you invest in Sectoral Funds?

The infrastructure funds have might performed well in one year. But over the next five-years, its performance fell considerably.

The strategy you need is to limit your portfolio exposure to sectoral funds. Morningstar recommends investors to limit their sectoral fund allocation to 5% of the total portfolio allocation.

You can take it as a thumb rule and adjust according to your risk preferences.

4. Investment Horizon

Apart from asset allocation, you need to consider the period for which you will stay invested in a sectoral fund.

Also read: How to use investment horizon to choose mutual funds

As sectoral funds are one of the categories of an equity fund, a long-term horizon is suggested. You may invest in sectoral funds if you have an investment horizon of at least 5 years.

5. Portfolio Tracking

Tracking the portfolio becomes the core of sectoral fund investment. Usually, for equity funds other than sectoral funds, you may follow a passive strategy.

But sectoral funds demand active investing from your end. Sectoral funds go through a cyclical process of fall and rise in a particular investment horizon.

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Timing the market becomes crucial. You need to decide when to enter and exit. Ideally, you need to enter a sectoral fund when the bearish phase ends. You may exit the fund at the end of its bullish phase.

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