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FundsIndia Views: The lowdown on sector funds

November 1, 2017 . Bhavana Acharya

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Why you should be wary of sector funds

  • Different sectors come to the fore in different markets
  • Returns are often deceptive as you can spot top performers only when a sector peaks
  • Limited choice of sector funds to play
  • Timing entry and exit becomes important in sector funds
  • If ill-timed, they can deliver negative returns even over 3 & 5-year periods

Look at the top performing funds in any year. Often, the toppers are sector-specific funds. In some years, the returns these sector funds post are far above that of diversified funds. Take 2017 for example. In January this year, the best one-year return was a whopping 44%, clocked by DSP BlackRock Natural Resources fund. The best return any diversified equity fund posted was 15%. In fact, of the top 10 funds eight were sector-specific.

Today, IDFC Infrastructure looks tempting with a 47% 1-year return. There are specific drivers such as the huge outlay on road construction that the government announced last week. But is this enough to propel the entire infrastructure sector? If it does, how long will the run last?

Investing in sector funds calls for a keen eye, the ability to keep track of stock markets, domestic economic developments, global developments, and knowing when to get out – even if it means booking losses. For most of us, the very reasons for investing in mutual funds are to circumvent these factors. This is why we usually advise against investing in sector funds as part of any portfolio. The new SEBI rules limit an AMC to a single fund per category except sectors and themes. If AMCs come up with new sector funds, it’s best to be cautious.

Before getting into the characteristics and risks of sector funds, know that there are two types of sector funds. The first type invests only in a single sector such as banking or technology. The second type is a fund that is built along a common theme, such as consumption or manufacturing. While the second type is broader than a pure sector fund, it is still just as risky. This is because you’re still betting on a specific driver or growth factor which has its peaks and troughs.

Timing is the key

One, in each market, different sectors come to the fore. A sector, once it falls out of favour, may not come back up for years. Consider infrastructure. Funds in this sector clocked 1-year returns in excess of 60% for much of 2007 and 2008, sometimes holding a solid 20 percentage points above regular diversified equity funds. This gap narrowed from mid-2008 onwards as the market crash hit. By end 2008, 1-year losses in these funds were 50-60%, sliding below the average for diversified funds. Infrastructure funds trailed in this manner right on until 2014 when the euphoria over the new government and reforms sent the sector up again for a while. By 2015, infrastructure fell back and then picked up again later in 2016.

Similarly, MNC funds were the rage in 2015 and 2016 when they trumped diversified funds by an enormous margin. The preference for low-debt companies with quality governance sent these stocks up as the market hunted for quality. This has now given way with the two MNC funds now trailing other equity funds. In each calendar, the top funds have always belonged to a different sector. If today it is infrastructure, the topper funds in January 2016 was pharmaceuticals. In January 2014 toppers were technology funds, in January 2013 it was banking.

Two, returns for sector funds swing sharply. Often, the one-year return catches the eye. And this is a bad metric to go by. The trick in sector funds is to catch it when the returns are low, not high. Returns in these funds rise very steeply, very quickly. Looking at the past returns and investing when it looks good simply means that you have lost the best of the returns already. These funds can also fall equally quickly.

Technology funds clocked strong 1-year returns in January 2014, with ICICI Prudential Technology and Franklin India Technology returning 61% and 53%, respectively. By January 2015, the two funds’ returns dropped to 30% and 18%. Today, the 3-year return of these funds is less than 5%. Another investor favourite last year was DSP BlackRock Natural Resources fund. In October 2016, the 1-year return was 51%. Today, the 1-year return is 44%.

On an average, the volatility in returns for sector funds is much higher than other equity funds – in the past five years, the deviation in their returns is on an average, 20% higher than diversified funds. The proportion of times they deliver losses, even on a 3-year or 5-year basis is much higher as well.

Therefore, this makes timing very important for both entry and exit. If you catch it too late, you lose the bulk of returns. If you fail to exit, your returns will slide into losses. Using the logic of holding on for the long-term may not work out if markets don’t pick the sector or if its fortunes change completely. The software sector is such an example today where there is a structural shift in the way they do business. If you run SIPs when the sector is trending up, you will be averaging your cost up. If you run SIPs in a sector that is falling out of favour, you will be throwing good money after bad.

The knowledge you need and the factors to look at are vast and varied too. Sector funds are a motley mix and thus the indicators to track are many. Commodities are driven by global factors. Raw material prices and spending patterns drive FMCG fortunes. Rural India is influenced by wage growth, irrigation and monsoon levels, crop yields, seed and fertiliser prices, and minimum support prices. Infrastructure depends on commodity costs, interest rates, government spending and finances, and state of the economy.

You would need to keep track of all these if you are to identify sector funds worth investing in and to know when to exit. It is of no use to track one or two sectors alone. Once you do exit the fund, you would need to find another investment opportunity to redeploy those proceeds. Besides, if you do have this knowledge and ability, you could always invest in a few stocks instead of a fund where you cannot control the portfolio!

Diversified funds do the same job

Choices are limited in sector funds. Of the 65 sector funds available, more than half are in infrastructure, banking, pharmaceuticals, and technology. Other sectors or themes have at best a couple of representative funds. There are only two FMCG, commodity, and MNC funds. Other single sector funds represent manufacturing, rural India, urban consumption, media, and power. Even if you were to spot a theme or sector correctly, your choice will be restricted. If that fund happens to be inept at managing the sector correctly, you may stand to lose even if your call to invest was correct.

Now, take the most populous sectors as far as sector funds go – banking and infrastructure. Banking and financial services, given that they are the single biggest contributor to the listed space, unfailingly find representation in every equity fund. Your portfolio would anyway hold a good part of this sector. Similarly, diversified equity funds today hold several sectors from cement to power to steel to engineering to construction. All these play into the infrastructure theme already. Holding an infrastructure fund over and above this simply increases your exposure.

Diversified funds take over the role of tracking sectors, booking profits, and reinvesting the proceeds in new opportunities. Depending on opportunities, funds pick up or scale back holdings in sectors. Over the past couple of years, for example, funds scaled back exposure to pharmaceuticals and software, traded in expensive FMCG stocks for cheaper durables stocks, picked up NBFCs instead of banks, raised exposure to oil & gas and pure construction companies and metals, and booked profits in media stocks. It is true that equity funds don’t all get their calls correctly – but then you have dozens of funds to choose from and you have past performance to judge their quality.

This apart, there are sectors with a lot of potential but without enough listed stocks to devote an entire fund to them. For instance, defence spending may be a good choice given the government’s focus here. However, there is no way to play this because there aren’t pure defence stocks to begin with, and the number of stocks that participate in such contracts are very few. Therefore, most sector funds currently don’t serve much of a tactical allocation, since the sectors are already held by diversified equity funds. For niche or fast-growing sectors too, regular equity funds are the only participation route.

At the end of all this, what if you still want to invest in sector funds? Well then, keep in mind these pointers:

  1. Don’t allocate more than 10% to sector funds as it ups your portfolio risk too much.
  2. Don’t keep them as part of your core portfolio or run SIPs in them for a long period. These funds should only be used to lift returns from time to time.
  3. Don’t go by 1-year returns or even 3-year or 5-year returns to make a decision. It will lead you to invest in sectors that have already run up.
  4. Use themes as far as possible, and not sector-specific funds as it spreads your risk a little better than sector funds.
  5. If you find all of the above cumbersome to follow, you will do well to simply stick to a diversified equity fund.

Mutual fund investments are subject to market risks. Please read the scheme information and other related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements before choosing a fund, or designing a portfolio that suits your needs.

Note: This article has been updated to provide more clarity around timelines of sector fund returns.

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