Mutual funds are a great way to build a diversified equity portfolio that can help you achieve long-term goals like wealth creation for retirement. However, there are multiple categories of mutual funds offering different types of exposure to equity markets. SEBI has created these categories to ensure that investors invest based on risk appetite.
For new investors, usually hybrid category mutual fund schemes are suggested to start their exposure with & then they can slowly move up to pure equity categories like flexi caps, mid-caps & small caps.
There are other categories that offer exposure to specific sectors or themes. These categories are often used by matured investors who are aware about the sectoral shifts in the economy.
In this post, we are going to discuss sectoral funds offered by asset management companies in India. The words sectoral and thematic are used interchangeably sometimes but there are differences, and we will highlight those too.
Sectoral funds focus on a specific sector or industry, such as technology, commodity, banking & finance, healthcare, or energy. These funds invest in companies that operate in that sector. The investment universe is very narrow as compared to that of thematic funds.
Thematic funds, on the other hand, invest in companies that are related to a specific theme or trend, such as housing sector growth, consumption theme, renewable energy, artificial intelligence, or e-commerce. The investment universe is quite broad as compared to that of sectoral funds.
Example: A banking sector fund has to invest a minimum of 80% of its corpus in banking companies only. However, a housing opportunities fund can invest in the real estate sector, banking sector, paints company, electronics & home appliances company etc.
Let’s try to understand the advantages & disadvantages of sectoral funds:
Focused exposure: Sectoral funds allow investors to concentrate their investments in a specific sector or industry, providing them with a more focused exposure. This can be particularly beneficial for investors who have a good understanding of the sector and believe that it has potential for growth.
Potential for higher returns: Sectoral funds may have the potential for higher returns than more diversified funds, especially if the sector or industry is experiencing a period of growth. However, it's important to note that sectoral funds can also be more volatile, so investors should be prepared for the possibility of greater fluctuations in returns.
Professional Management: Sectoral funds are managed by professional fund managers who have expertise in the particular sector they invest in. These managers conduct extensive research and analysis to identify the most promising companies within their sector. Investors can benefit from the expertise of these managers without having to spend the time and effort required to conduct their own research.
Higher Risk: Sectoral funds are generally riskier than diversified funds because they are more narrowly focused. The performance of the fund is heavily dependent on the performance of the sector it invests in. If the sector experiences a downturn, the fund's returns may suffer. Also it could sometimes happen that the sectoral call is not working and the investment is not generating enough returns to beat the opportunity cost.
Limited Diversification: Although sectoral funds are diversified across companies within a particular sector, they are not diversified across multiple sectors. This can leave investors vulnerable to economic or market changes that affect the sector the fund invests in.
Cyclical Nature: Some sectors, such as infrastructure and healthcare, can be highly cyclical, meaning they are sensitive to economic cycles and market trends. Investing in a sectoral fund that is highly dependent on one of these cyclical sectors can result in highly volatile returns.
Timing: It is important to note that one has to time the entry & exit correctly to generate above average returns in sectoral funds. Exit is the most important factor because investors must know when the theme has played out & when to take money off the table. This requires special skills & a lot of research.
Who should invest in sectoral funds?
- An investor who is willing to take high risk for generating better returns than an average diversified fund. These funds invest in a specific sector and this lack of diversification means these are one of the riskiest mutual funds available.
- Investors having specific knowledge about how a particular sector operates & positive & negative triggers for the sector.
- Investors who are looking to make a small tactical allocation towards a particularly undervalued sector.
A diversified mutual fund scheme provides better risk adjusted returns in the long-term for investors. It is difficult to keep track of a particular sector & time the entry and exit in an accurate manner. Investors are suggested to take help from the advisors in case they are looking to make tactical allocation towards sectoral funds.
Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited