Sectoral funds are Mutual Fund schemes which invest only in securities or shares of a chosen sector. They are not diversified funds which have exposure to different types of securities from across several sectors. Since the portfolios of such sector funds are completely concentrated in companies operating in the same and related sector, the risks involved are much higher than a diversified fund. Though risks are high, so are the rewards, if investors have strong risk appetite.
For instance, if there is an equity sector fund, say a Pharmaceutical/Health Care Fund, the holdings of the scheme will be only drug makers and hospitals – small, mid or large players. Similarly, if there is a banking fund, the portfolio of such a fund will contain only banks and financial institutions. Investors could treat these funds as peripheral investments and not as the core of their entire portfolio. This means that you should allocate small parts of your investments towards sector funds. It is preferable to invest in these funds when the sector is in a downturn, as a recovery would help you accelerate wealth creation.
If you plan to invest in sector funds, here are some of the important features of such schemes which you should know before investing.
Sector funds invest in companies of the same sector and therefore are highly concentrated in nature. The portfolio construction is such that dominant, well-established companies in a sector get the lion’s share of allocation of the scheme’s overall assets. This adds one more layer of concentration risk. Depending on the fund manager’s decision, it is not surprising to see nearly half of a sectoral fund’s overall assets being cornered by the sector’s top 3-5 companies. The only diversification such funds offer is inclusion of large, mid and small cap companies from the same sector in the portfolios.
High Risk-Reward Ratio
Since sector funds run a concentrated portfolio, risks associated are relatively much higher. In case the sector is not doing good, it will impact the entire companies; thereby significantly impacting the fund value of sector schemes. However, it is equally true that once the business cycle turns better, all companies of the sector are positively impacted. This brings a steep spike in the investment value and rewards investor quite handsomely.
Sector funds are not the flavour of all seasons. Their performance is cyclical in nature; it depends on the business sentiments in the sector and for its companies. Business sentiments do not remain the same all the time. Investments made in such funds during bad times work well for investors if they have high risk-appetite capabilities and can wait till the cycle reverses.
Incremental Value Impact
Given the higher risk-reward ratio in sector funds, there are times when such schemes add tremendous incremental value to your overall investment portfolio. Such value creation could be steep and in a much shorter time span. However, when this time span will start is anybody’s guess. The key for investors remain that they need to be patient and not panic when the sector struggles during downturn.
The portfolio value of sectoral funds generally witness comparatively higher volatility. Since underlying securities are from the same sector, an adverse development in the sector can negatively impact all the holdings while a positive state of affairs can uplift the sentiments across the board. One should know that performance of sectoral funds do not reflect or is not in line with the trend in the broader market most of the time. Broader markets have all kinds of securities from several sectors bringing in a relative stability. However, it’s not generally applicable on sector funds.
The writer is CEO, BankBazaar.com.