Should You Have Sector Funds in Your Portfolio?

As Indian equity markets mature, investors are no longer limited to the broad-based mutual funds. The product landscape has grown to offer more targeted products, including sector funds. These funds target one industry; it could be the banking industry, information technology, pharmaceutical, or infrastructure.

The major issue is that the investors are not asking whether sector funds can make returns, but whether they can be incorporated in a disciplined portfolio structure. Sector funds can have the potential to magnify outcomes, both positively and negatively. This makes them more strategic rather than incidental in their role. Before committing capital, it is important to have a good understanding of how they work, where they create value, and where they create risk.

In this blog, you can expect a clear breakdown of what sector funds are and how they work, an objective look at the risks and limitations of sector funds, and much more.

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What Are Sector Funds?

Sector funds are a category of equity mutual funds that invest mostly in companies in a particular sector of the economy. Simply put, the sector funds' meaning refers to mutual funds, which do not spread investments across multiple industries but instead concentrate on one specific industry.

Sector funds, unlike diversified equity funds, focus their exposure on one area.

For example, a banking sector fund normally invests in public and private sector banks, non-banking financial companies, and other financial institutions. Similarly, a technology sector fund invests in businesses involved in software, IT services, and technology-enabled solutions.

This concentration is the defining characteristic of the sector funds and is also the source of their different risk and return profiles.

How Sector Funds Differ From Diversified Equity Funds

Before diving into a comparison of the two, it's important to understand the key difference regarding approach. Although both of them are equity mutual funds, they fulfil different purposes. Diversified equity funds are focused on balance and stability, whereas sector funds tend to capitalise on specific industry opportunities.

Why Investors Are Interested in Sector Funds?

Sector funds appeal to investors seeking to get more than a general exposure to the economy and to exploit particular opportunities within the economy. The following are some of the important reasons why some investors prefer to add sector funds to their portfolios:

Potential to Tap Sector-Led Growth

Economic cycles go through stages like recovery, expansion, and slowdown phases, with each phase being favourable to different sectors. For example, banking from increased credit demand, infrastructure from increased policy-led expenditure, and technology from the strong global demand. Sector funds let investors position portfolios to these cycle-driven sector opportunities.

Strategic Allocation Opportunities

Some investors use sector funds for tactical allocation as opposed to using them as a permanent holding. This strategy means entering a sector when fundamentals are favourable and having reduced exposure when valuations return to more reasonable levels.

Portfolio Customisation

Sector funds give investors a voice for their views that might be diluted by the diversified funds. For investors who have a strong conviction on the medium-term prospects of a particular sector, these funds provide direct and targeted exposure.

Risks Attached to Sector Funds

While sector funds can help in adding to the returns when conditions are in favour, they also involve higher risks when compared to diversified equity funds. Their laser-like nature means that outcomes are closely linked to how a single industry is doing, and as such, they are unsuitable for investors seeking stability or low volatility. The following are the major risks investors should know:

Concentration Risk

By design, sector funds are very concentrated. If the selected industry performs poorly due to changes in regulations, cyclical slowdowns, or structural difficulties, the fund can perform poorly regardless of market conditions.

Timing Sensitivity

Returns from sector funds are highly dependent on the time of entry and exit. Unlike diversified funds, sector funds provide less insurance if investments are made late in the cycle, as they are less able to absorb downturns in a specific sector.

Prolonged Periods of Underperformance

Sectors may be out of favour for long periods of time. Investors can experience long drawdown periods while waiting for a recovery, and this can test one's patience as well as investment discipline.

Who Are Sector Funds Suitable For?

Sector funds are not for all investors. They may be appropriate when:

• The investor already has a stable core portfolio
• There is a clear understanding of sector dynamics and associated risks
• Allocation is proportional and narrowly limited
• The investment horizon is in line with the respective sector cycle

They are inappropriate for a first-time investor or when the portfolios are focused on a single equity fund.

What Is a Reasonable Level of Exposure?

There is no hard and fast rule for allocation, but sector funds are generally utilised as satellite holdings and not core positions. A small allocation helps to make sure that the volatility of sectors does not prevail in the overall performance of the portfolio.

It is imperative to maintain balance. Excessive exposure to one sector can cause a portfolio to have too many sources of risk that are beyond the company-level fundamentals.

Thematic Funds vs Sector Funds

Sector funds are associated with one industry, while the thematic funds have investments in many sectors tied to a common theme, such as consumption, manufacturing, or digital transformation.

The thematic funds tend to be more diversified, whereas both have focused strategies. However, they still have a greater risk than diversified equity funds. Knowing this difference also enables investors to match product choices with their risk and investment goals.

Role of Valuations in Sector Investing

Sector performance is closely associated with valuations. Strong past returns can attract inflows, which can carry valuations to beyond fundamental levels. The possibility of investing at high values may restrain returns in the future, although the industry might be expanding.

Sector investing should be considered with respect not only to growth potential but also valuation discipline.

Substitutes of Sector Funds

An investor looking to get a low concentration risk sector exposure would consider:

• Diversified equity funds - Sector tilted
• Funds tracking the market indices.
• Dynamic or flexi-cap funds that have sector flexibility

These options enable taking part in sectoral growth while maintaining the benefits of diversification.

Portfolio Role: Improvement and Not Establishment

Sector funds are portfolio improvement tools as opposed to base holdings. Their effectiveness is not in the performance they can have on their own, but in their ability to complement other investments.

When applied selectively, they may provide directional exposure. When used in excess, they will distort the risk profile of a portfolio.

Conclusion

Sector funds offer a narrow exposure to particular components of the economy, as well as increased volatility and timing risk. They are not replacements for diversified equity funds, and they are not usually core holdings of most investors.

For well-diversified, long-term portfolios, sector funds may have a defined and limited role to play. The decision to include them should be based on portfolio structure, risk tolerance, and ability to monitor sector-specific developments.

In equity investing, concentration is the magnifier. Whether this works in an investor's favour depends upon preparation, proportion, and patience.