What are sectoral funds and who should invest in them?

Another way of navigating the vast ocean of the Indian equity markets would be through sectoral funds. Such funds would allow you to benefit from the (perceived) growth of a particular sector across the board, without worrying about cherry-picking the individual stock of the sector.

However, be aware that such funds are highly concentrated in risk and may end up putting a dent in your portfolio if the sector goes South.

“When investing in a sectoral fund, investors must be aware that the investment experience into such sectoral (or sector-focussed) funds largely depends on getting the entry and exit points right,” says - Chintan Haria, Head - Product Development & Strategy, ICICI Prudential AMC.

READ MORE: What are sectoral funds? Here's all you need to know

Simply put a sectoral fund is one which invests in a particular sector or industry.

So as a basic guide, a sector like say banking and auto are cyclical and go through ups and downs based on their business dynamics and overall macroeconomic factors.

On the other hand, themes such as infrastructure depend on the direction of economic growth.

“The equity market is made up of many sectors, however not all sectors move in tandem,” says Shibani Sircar Kurian, Senior EVP & Head- Equity Research, Kotak Mahindra AMC (Asset Management Company).

As another guide, some sectors are more geared to the domestic economy while others may be more geared to global outcomes. Some are more cyclical in nature while others may provide a medium to long term opportunity to participate in the domestic growth opportunities.

One important benefit of a sectoral fund is that this investment theme provides an investor with an opportunity to invest in a particular sector while diversifying exposure across large , mid and small cap stocks in that particular sector.

If an investor is new to equity investing, then it is better off to start with a diversified equity fund.

READ MORE: Mutual Fund Investing: Should you invest in sectoral funds to chase higher returns?

So for what sort of investors are sectoral funds suitable?

“These funds would typically be better suited for investors who are well informed and those who are active investors with a medium to long term investment horizon and those who are aware of the investment risks associated with a sectoral fund,” says market experts.

The key to investing into sectoral funds are two – research/knowledge of the sector and knowing your (investor’s) investment priorities.

“Sector funds as the name suggests invests in a particular segment or industry, thus look for the following characteristics when investing into sectoral funds,” advices Kurian. First, is the characteristics of a particular sector, next understanding where the sector fits in the asset allocation strategy and risk appetite of the particular investor and finally choosing the right asset manager.

As a starting point, the investor needs to be clear about his/her investment goals and time horizon and risk appetite. Investors must understand that some sectors are more cyclical in nature (where the investor would need to be more tactical) while others maybe be more structural (where the investor would invest for the long term).

Hence, the investor would need to research the sectors which are most geared to his / her investment goals and risk appetite. “Finally, the investor needs to decide on the percentage allocation to be made to the sector in his/ her overall portfolio depending on the asset allocation strategy of the investor,” notes Kurian.

Within the sectoral funds segment an investor has the option of both actively sector or thematic funds, or passively managed index funds or ETFs.

A common mistake is that investors tend to invest in sectors which are trending at a certain point in time but the investors need to check whether the current momentum can be maintained over the next few years and whether the valuations are attractive enough at the current growth rate for wealth creation opportunities in that particular sector.

Please remember that when a sector delivers a return after an extended period of underperformance it is challenging to time the bottom and most investors enter at a relatively higher level thereby leading to a bad investment experience.

Selecting the particular sector to invest in as well as the individual stocks that you may feel will appreciate within that segment as well as knowing when to enter may be challenging for the investor.

“I suggest that an investor consult with a financial advisor for the way forward,” says Haria.

If investing through an AMC (Mutual Fund) look at the Asset Managers’ investment philosophy, investment process and team, advises Kurian.

Sectoral funds which are usually equity based have a degree of liquidity, if a quick exit is a need of an investor.

“In terms of investment horizon, depending of course on the sector chosen, one must typically look to invest for the medium to long term,” says Kurian.

Time in the market is more important that trying to time the market, is a common equity aphorism. Similarly trying to time a sector to perfection may be risky.

Sectors typically will follow patterns and the length of cycles vary across sectors. Hence a longer term investment horizon allows more time for the sector to navigate business cycles and also allows time for the sector to grow and achieve its potential.

READ MORE: These sectoral funds gave more than 17% return in past 5 years; Should you invest?

Sectoral funds and the broader markets

“Every sector has its own bull, bear and sideways phase,” explains Haria when asked about the comparison of sectoral funds versus the broader equity markets.

Thus, at the onset of the pandemic in 2020 and in 2021, software companies logged in gains due to the work-from- home regime taking shape thereby attracting digital transformation deals from global clients. This led to tremendous growth in revenue and profits.

As a result, the S&P BSE IT index gained 55% in CY21 and 56% in CY20. But since the start of 2022, on a year-to-date basis, the S&P BSE IT index is down 21.6% due to recession worries in developed economies of North America and Europe, resulting in lower budgets and spending.

“In terms of sectors, on a five-year basis, three themes namely IT, energy and finance have outperformed the broader markets,” says Haria.

Sectoral funds and taxation aspect

The taxation aspect is similar to that of any other equity-oriented fund. Long-term and short-term capital gains are applicable in the case of index funds. The rate of taxation depends upon the holding period.

In the case of equity-oriented index funds, if the holding period is less than 12 months, the gains are classified as short-term capital gains and if held for more than 12 months, the gains are classified as long-term capital gains. Short-term capital gain is taxed at a flat 15% while long-term capital gains above Rs.1 lakh are taxed at 10%.

Manik Kumar Malakar is a personal finance writer.