Best Sector Funds - MF Explorer

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Sectoral Funds

What are sectoral funds?

If there is one piece of investment advice most of us have been given, ‘don’t put all your eggs in one basket’ could easily be it. But sectoral funds do just that. According to SEBI’s Categorisation and Rationalisation of Mutual Fund Schemes, sectoral funds / thematic funds are funds with a minimum investment in equity and equity related instruments of a particular sector / particular theme. The minimum investment in the sector / theme that has been stipulated by SEBI is 80%.

Where do sectoral funds invest?

According to the investment mandate, sectoral funds are equity funds and have to invest at least 80% of their assets in equity and equity related instruments. The remaining 20% is at the discretion of the fund manager. This equity investment is made in companies pertaining to a specific sector only (in investing parlance, sectors are groups of companies with similar businesses) such as pharmaceuticals, real estate, IT, healthcare, banking & financial services, infrastructure etc. 

This makes sectoral funds very focused as against thematic funds which are a bigger umbrella and could cover many sectors under a common theme such as ESG, MNC, recently listed IPOs etc. Since thematic funds are broader than sectoral funds, they may be relatively more diversified and therefore to a limited extent, less risky than sectoral funds. Thematic funds are similar to sectoral funds in terms of risk and return, even though they can be broader in scope than sectoral funds.

While sectoral funds are focused on the equity of a particular sector, they are free to invest across market capitalisations within that sector.

What is the nature of returns from sectoral funds?

While sectoral funds bring the possibility of very attractive returns if you have picked the right sector at the right time, the risks that they bring with them cannot be overlooked.

Risk in a concentrated dose

Sectoral funds are heavily focused on one sector and are therefore naturally vulnerable to anything that may impact the sector. While when the sector is on an upswing, the returns may be outperforming the market. During a low, sectoral funds could wreak havoc as anything that impacts the sector will be felt more acutely on the fund focused on that sector. If the sector has been adversely hit, like some sectors were during the Covid-19 pandemic or if the sector has not been recognized as a performer by the market, the fund could go through long phases of under-performance. A long term holding doesn’t necessarily smooth out this volatility and deliver returns in sectoral funds, unlike other mutual funds.

Due to this, sectoral funds are more prone to volatilities and fall on the riskier end of the spectrum of mutual funds with the Riskometer routinely pointing to ‘Very High’. In terms of concentration risk, thematic funds which are broader are less risky – however, themes, like sectors, may also have their ups and downs. There are few thematic funds that are broad enough or are in themes that can be part of long-term portfolios.

Timing is key

Many sectors need entries and exits to be timed to be able to make meaningful returns from them. This means that, investing in sectoral funds requires you, as an investor, to be very switched-on. For instance, commodity stocks’ performance is closely tied to the price of the commodity in question. As an investor, one needs to be clued in to know when the cycle is down in order to make an entry that will allow him / her to benefit from the upcycle. Similarly, timing profit booking too is crucial as a down-cycle in that sectoral fund can wipe out returns. Further, many sectors are cyclical (for instance the automobile sector) and here again, would require timing to be able to make returns. Hence, even if you have picked the right sector, knowledge and vigilance could be crucial in helping you profit from it.

Some may test your patience

Some sectors can despite very attractive valuations, spend a lot of time being the laggards, like PSU stocks. Here, not only does the entry have to be timed but an investor would have to be prepared to wait it out until the bets start showing results.

So while sectoral funds or thematic funds offer the possibility of super-normal returns, they also come with very high risks of getting the sector or theme wrong or getting the timing wrong or the sector/theme not working out in the window of time that you originally expected it to. They may do well in some market cycles but drag down the portfolio in others. This makes sectoral funds and thematic funds a high risk – high return category of funds.

Suitability

  • Since sectoral funds are primarily equity oriented schemes, they would require an investor to have a long term time horizon of not less than 5 years. This apart, since sectoral funds are very high risk, they cannot be held in short-term portfolios as this does not leave room to recoup from any loss that you may suffer from sectoral funds.
  • Therefore, long term wealth creation portfolio are where sectoral funds or thematic funds could find a place.
  • But a long time horizon is not all that is required to be successful with sectoral funds. Any investor looking at sectoral funds would need to have a very high tolerance for risk in order to be able to stomach the possible volatility and capital erosion, especially if the timing, or worse, the choice of sector is wrong.
  • The size of portfolio too would need to be large enough to justify the diversification and added risk from a concentrated fund like a sectoral fund or a thematic fund. If the portfolio is too small, then adding a sectoral fund to diversify could do more damage than good right from adding to the complexity in monitoring the portfolio to dragging down overall performance. So if you are just starting out on your wealth creation journey or your portfolio is not large, then a diversified equity fund could be a better friend for you rather than a sectoral fund.
  • If you meet all the above criteria and are looking to give returns a leg-up, sectoral funds could form the high return component of your portfolio. However, this would require considerable homework on your part to keep track of markets and sectors to know where and when to invest and exit. If diversification is what you are looking for then thematic funds with a wider coverage could help. Here too, homework is key to be tuned in to know which themes will work and which one will not.  
  • Once invested in, sectoral funds are not the type of funds that you can forget about and let run on auto pilot. Depending on the sector, they could require varying degrees of active monitoring, especially if it is a sector that requires you to make a timed exit to be able to benefit your portfolio.
  • You would also need to consider if the sector you are keen on already finds a place in your portfolio through other diversified equity funds. For instance, banking and IT stocks could find a place in many diversified equity funds.
  • If you still believe sectoral funds should find a place in your long term portfolio, sectoral and thematic funds should not form more than 10% to 15% of your overall portfolio. Further, this limit could be split across funds to minimize overlaps.

What is the benchmark index?

The benchmark index is the index against which the fund’s performance is evaluated. Which index the fund is benchmarked against will depend on the focus area of the sectoral or thematic fund. Banking and Financial Services sector funds could be benchmarked against the Nifty Financial Services or its total return version or the Nifty Bank.  A thematic fund focused on the infrastructure sector could be benchmarked against the Nifty Infra or the S&P BSE India Infrastructure Index – TRI.   The S&P BSE Healthcare or S&P BSE Healthcare TRI could be benchmarks for healthcare focused sectoral funds. Other commonly used indices by sectoral funds and thematic are:

  • Nifty Consumption, Nifty Consumption TRI
  • S&P BSE METAL Index
  • Technology S&P BSE TECk Index
  • Nifty FMCG, Nifty FMCG TRI
  • Nifty Commodities – TRI
  • S&P BSE Information Technology – TRI, NIFTY IT

Taxation

Sectoral funds are a type of equity mutual funds and are therefore taxed accordingly.

  • IDCW distributions are taxed at the hands of the investor at the applicable slab rate.
  • Short term capital gains (holding period less than 12 months) are taxed at 15%. Long term capital gains (holding period of 12 months or more) above Rs. 1 lakh are taxed at 10%.

Evaluating your options in sectoral funds

Evaluating sectoral funds comes with its own set of challenges but the following points could help.

  • To start with, one would need have a good understanding of the sectors one is interested in to know how they work, when they are in an upswing / down cycle, when they are likely to pick up etc. This is no mean feat.
  • The fund’s track record would be useful in evaluating. However, if one only looks at the recent historical performance of the fund, it may be misleading as one may miss important aspects especially if the sector is one that is cyclical or one where timing is important.
  • Expense ratios

Here, we can help in the following ways:

  • If you are convinced about the prospects of a sector or a theme, Theme Park can help you take things forward by telling you which the best funds to play the theme are.
  • If you are curious but not yet knowledgeable about sectors, take a look at Prime Funds. The Strategy / Thematic section has a list of the funds that we think are the best. The ‘Why this fund’ section will tell you more.
  • Our article, ‘How you should use sector funds’ is an absolute must-read before you take the plunge into sectoral funds.
General Disclosures and Disclaimers
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