Should I invest in Sector Mutual Funds?

Whenever a sector or theme starts doing well in stock markets, investors get excited about it. They see an opportunity to generate better-than-average returns by investing in a sector fund that is poised to grow faster than the rest of the market.

And to use this excitement to their benefit and to gather more AUM, the AMCs launch new sector funds (or start promoting existing ones again). And unsuspecting investors get attracted to these funds like bees to flowers.

But if you think about it, you will notice that one sector or the other will always to better than the market (or the index). There is nothing rare about it. Right?

Sometime, pharma will do better than others. At other times, auto might do well. Then the time of financials might come. So it’s a musical chair of sorts in the long term. Like dogs, every sector has its day. It happened with tech stocks in the late-90s. Then came the infrastructure story of 2006-07. History just keeps on rhyming if not exactly repeating.

As is evident by its name, a sector fund is an equity mutual fund scheme that invests most of its portfolio in stocks of one particular sector. There are different types of sector funds. Like FMCG funds, Pharma funds, Technology funds, Natural resource funds, energy funds, healthcare funds, precious metals funds, financial services funds, banking funds, etc. These sector and thematic funds have their own separate category in the mutual fund categories.

Why do people wish to invest in such narrowly-focused sector funds when well-diversified funds are already available? Because they feel that a particular sector is poised to give better returns. So by taking exposure to that sector (and overweighing it in their MF portfolio), they can generate potentially better returns. It’s like taking a bet on a particular sector.

To be fair, there is nothing wrong with that line of thought.

No doubt, sectoral funds can provide attractive returns. But for that, you have to get your investment timing right. And you also need to time your exits from such sectoral bets carefully. Remember, good days for a sector will not last forever. They cannot because every sector and industry follows its own unique business cycle.

So if you invest in a sector fund that invests in stocks of industry that is just about to do very well, then you can earn superior, market-beating returns. But eventually, the law of averages will catch up and when the industry turns a corner and faces headwinds, it can lead to significant losses to sectoral funds as well.

So it’s like trying to ride a wave. You just want to climb a wave at the right time (or a little bit earlier) and then ride it for as long as it stays strong. And then when the wave is about to crash, you just get off it. Easier said than done. But that’s how it is.

You got to leave the party before it’s over. And if you join the party late and stay long, then it will lead to losses. The sector fund can show losses due to change in the sectoral environment even though the broader market might be doing well at the same time.

By the way, there is a slight difference between a sectoral and a thematic fund. Though for simplicity, I am only referring to sector funds here. A fund that invests only in one sector is a sector fund. At times, fund managers want to take thematic bets. Like for example rural themes. So they can invest in sectors which are expected to benefit for rural theme like agri-oriented stocks, fertilizer stocks, vehicles, micro finances, etc. naturally, the sector funds have greater concentration than thematic funds (although both are far more concentrated than simple diversified equity funds).

For lack of a better word, Timing is the key when investing in sector funds. If you time your entry well, you are in for super-profits. But returns will moderate and turn to losses eventually. So, accept the fact that the returns of sector funds can swing sharply. And hence, just looking at the last 1-year returns of a rising sector and investing in it is not the right approach.

Once a sector goes out of favour, it may not come back up for years.

In fact, if you are looking at the past 1-2 years of good returns and then investing, it actually means that you are already late for the party. You have already missed out on the best of the returns already. The party may still continue. But you never know if it might just be about to end when you plan to enter it.

Investing in sectoral bets (or sector or thematic funds) requires a good understanding of the sector or industry. It goes without saying that there are several variables in any sectoral equation. And if you do not have a good understanding of how the sector works and what affects what, then you will not know when it’s a good time or a bad time to be in a sector. Just because AMCs are launching new sector funds doesn’t mean they will all do well. It might. It might not. AMCs have other incentives for launching new funds.

So

Should you invest in Sector Funds?

It’s simple.

Most investors are better off not having sector funds in their mutual fund portfolios. Well diversified equity funds are best for them.

But please understand that I am not against sector funds. I am just saying that sectoral mutual funds are not for everyone. They can give huge returns at times. But they are also vulnerable to high volatility and large losses. And that is not something that many can handle (in any case, people overestimate their risk appetite every now and then).

If you have a good understanding of the sector and the risks that come with investing in a narrow theme, only then should you consider investing in sectoral/thematic funds. Also, timing the entry and exit of the investment is something that you need to be sure of. And even then, it’s not right to make it your core holding. Just limit it to 10-15% of your portfolio.

It’s easy to say that ideally, you should try to invest when the sectoral up-cycle is starting. But to identify such entry points, you need to understand the sector well and also many other things. And then the point comes – if you are so good that you are able to identify such opportunities well in advance, why don’t you invest in stocks of the sector directly? Isn’t it?

And how to invest in sector funds?

Lumpsum vs SIP in Sector funds?

Ideally, sector funds are more about timing so it is better to do a lumpsum investment. But only if you really are making an informed call and know what you are doing. But if the lump sum isn’t available, then SIP investing is still fine. But it’s best to do SIP in a sector fund that is not doing well currently but as per your view will return to the spotlight in the next few years.

That’s it. Not much to add here.

Just remember that every now and then, a new sector will start doing well. But don’t get carried away by the short-term performance of sector funds and invest in them. It’s not as easy as it looks. Investing in sectoral or thematic funds requires you to make informed calls (and not go by gut calls or hunches). And most small investors generally don’t have the kind of expertise and understanding required for playing the cyclical nature of sectors for their profits. Timing your entry and exit is quite important in sector funds.

Most of you are better off with plain and simple well-diversified equity funds. And let’s not forget why you started investing in mutual funds in the first place. Because you wanted diversification and not concentration. Isn’t it?

Sectoral funds aren’t bad per se. But they are not suitable for most people. And hence, it’s best to avoid investing in sector funds when building long-term portfolios.