Losing out on the diversity factor

Specialised or sectoral funds are in a way a risky proposition as they do not offer investors the diversified portfolio that mutual fund plans are expected to do.

The article does not purport to denounce sectoral schemes but merely caution investors on the perils of investing in such schemes.

There are several investors who invested in technology schemes at the height of the dotcom bubble in 2000. Suffice to say most have not recovered their initial investment even after four years as the net asset value of most schemes are way below their par value.

Generally, fund houses launch sectoral schemes only when the valuations in the sector are peaking. Look, for instance, at tech schemes that were launched in 2000. Most of them were launched during February and March in that year.

In April, the markets started tanking! Very few fund houses launch a sector fund when the stocks are not doing well, for the very simple reason that no investor will invest in it.

Given the fundamental reality, investors in sector funds need to take a long-term view unlike in the case of an ordinary diversified equity fund. This is because every sector has its ups and downs "" we are not talking cyclicals here. So, wait out the downturn.

It could take six months or even two years, but wait it out. That sector will come out tops again. Let us talk about risk factors now. Volatility in sector funds is much higher than in the case of other funds.

In its latest issue, Value Research, a mutual fund tracker, has done a cover story on sector funds. Its analysis has said, "Volatility (of sector fund returns) tends to be in the range of 8.5 to 11, while that of diversified equity funds ranges from around five to nine with the bulk of funds below seven."

The article adds, "Sector funds can sound quite attractive, but their high volatility means that your returns can jump around severely. Is the ride worth it? The simple answer to this question is 'No.'

But if you are hell-bent on investing in a sectoral fund, take some simple precautions. If possible, avoid investing in the initial public offering (IPO).

Or, if you have to, check out all the stocks in that sector and track their prices over the last one month. If there has been substantial appreciation of the prices (say, 40 per cent or more) then give the IPO a miss.

Look instead for a sector fund that has been around for some time. That sector may not be doing well for some reason. Find out what the factors are "" is it external or internal and the chances of it getting resolved in the near or medium future.

An ongoing example of this is metal stocks. Metal stocks are all the rage now, and they still are "" but there seems to be a temporary correction, owing to hedge funds selling on the LME and demand from China cooling down.

Both are temporary phenomenon and you would not be wrong in remaining invested in metal stocks.

If the sector is doing well, check out the NAVs "" how much they have appreciated over the previous month and then invest in it.

While investing in a mutual fund follow almost the same rules that you would while investing in a stock "" only advantage is that the fund manager is churning his portfolio for you "" so the risk is much lesser.

The one-way street

• Generally, fund houses launch sectoral schemes only when the valuations in the sector are peaking
• Very few fund houses launch a sector fund when the stocks are not doing well
• Investors in sectoral funds need to take a long-term view
• Weather the ups and downs in the sector and wait it out
• Volatility in sector funds is much higher than in the case of other funds
• Avoid investing in the initial public offerings of sectoral funds
• Look instead for a fund that has been around for some time