Capitalise on the industry insight by investing in its sector fund

Choosing such a fund based on recent returns can, however, jeopardise portfolio performance

Sector funds like automotive (25.9 per cent), pharmaceutical (23.3 per cent) and information technology (21.8 per cent) are among the best-performing categories year-to-date among equity funds. Investors are flocking to them in large numbers. According to data from the Association of Mutual Funds in India (Amfi), these funds attracted inflows of Rs 4,805 crore in August, outpacing all other categories of mutual funds (MFs).

The allure of recent returns

One driving factor behind investors gravitating towards sector funds is recency bias. They are essentially getting drawn to categories that have exhibited strong performance in the recent past. “At any point of time, some sector funds display high past performance. Their returns often eclipse those of broader indices like the Nifty50. Investors, hence, get attracted to them,” says Ankur Kapur, investment advisor, Plutus Capital.

August saw the launch of several new fund offers (NFOs) in the sectoral-thematic domain. “Five such NFOs mobilised Rs 2,556 crore,” says Abhishek Kumar, a Securities and Exchange Board of India or Sebi-registered investment advisor (RIA) and founder, SahajMoney.

Distributors push sector funds because they offer higher commissions. “About 79 per cent of retail investors and 74 per cent of high net worth investors invest in mutual funds via distributors. The commission paid by some of these schemes is 10 times higher compared to others. Schemes that pay higher commissions get pushed,” says Avinash Luthria, a RIA registered with Sebi and founder, Fiduciaries.  

Profitable if you get timing right

Sector funds can at times be profitable. “Investors who get the entry and exit timing right can earn a decent profit through sectoral allocation,” says Kumar. However, getting the timing right consistently is not easy.

Some people have sound insights into a particular sector. “If a sector they are knowledgeable about faces a downturn, they might spot an opportunity to capitalise on what they regard as an overreaction, and potentially earn high returns,” says Kapur.    

Some investors may invest in sector-thematic offerings because they align with their religious beliefs. Says Luthria: “The only use case for sectoral or thematic funds is if the investor’s values or religion forces them to use funds that avoid the sin sectors. Such investors may invest in a Shariah fund or an ethical fund.”

Brace for a roller-coaster ride

Returns of sector funds can fluctuate sharply from one year to the next. “Extrapolating recent returns into the future can create an unpleasant experience,” says Kapur.

In a bear market, sector funds usually take a more severe beating than their diversified peers.

Their concentrated nature causes another problem. “If the sectoral bet doesn’t work out, the whole fund underperforms, unlike a well-diversified fund which has exposure to various sectors of the economy,” says Kumar. Some parts of a diversified fund’s portfolio are likely to perform at any given point.   

Luthria points to the high total expense ratio (TER) of these funds (which weigh down their net return). “Additionally, the tendency among investors to chase the latest investment fad can result in higher tax liabilities due to frequent portfolio reshuffling,” he says.

Individuals heavily invested in sector funds of the industry they work in may face a double whammy during downturns — a possible job loss or pay cut paired with a drastic erosion in portfolio value.

Are they worth the risk?

Invest in a sector fund only if you have special insight into that sector, or if your religious views allow you to invest in some of these funds only. Kumar suggests that those with lower risk tolerance should steer clear of these funds.  

Those venturing into the sectoral-thematic space should avoid funds that have done well recently. “Those funds have already run up and are likely to offer suboptimal returns in the future,” says Kumar. Avoid allocating more than 5-10 per cent of your equity portfolio to these funds.