10 things to keep in mind before investing in sector funds

Factors like timing the entry, deciding total exposure to the sector, conviction and staying power matter a lot for sector funds.

Apr 15, 2021 10:04 IST India Infoline News Service

Sector funds were the toast of FY21 with certain themes doing extremely well. You normally hear the argument that sector funds are concentrated and hence entail greater risk. Here is a quick review of four popular sector funds in India.

Sector Fund 1-Year Returns 3-Year Returns 5-Year Returns 10-Year Returns
Technology Funds 124.90% 30.77% 22.83% 17.49%
Healthcare Funds 53.39% 22.69% 12.13% 16.07%
FMCG Funds 26.83% 7.64% 12.91% 15.31%
FinServ Funds 61.06% 5.71% 13.73% 6.34%
Large-Cap Funds 56.78% 11.63% 14.39% 10.45%
Multi-Cap Funds 61.92% 10.61% 14.53% 12.09%
Mid-Cap Funds 81.41% 10.26% 15.57% 14.92%
Data Source: Morningstar
Technology funds gave CAGR returns of 17.49% over last 10 years and beat large cap, multi-cap and mid-cap funds across time frames. Healthcare funds beat generic funds over a 3-year period and 10-year period while FMCG funds beat generic funds over a 10-year period. There is merit in opting for sector funds if you can get your view on the sector right. Follow these 10 steps before investing in sector funds.
10 things to keep mind before buying sector funds
Assume you bought  a Pharma Fund in 2013. The fund would have gained value till 2015 and then consistently lost value. Obviously, by 2020 you must have lost your patience and sold out only to be disappointed by the 54% rally in pharma funds in FY21. That is why factors like timing the entry, deciding total exposure to the sector, conviction and staying power matter a lot for sector funds.
  1. Don’t buy sector funds on the FOMO factor. Fear of missing out (FOMO) is an important reason why investors buy sector funds. The risk is that  you end up buying as a herd and the best part of the story may have been over by then. Don’t get pushed into sector funds by herd mentality.
  2. A great idea may not give great returns. This is important if you are buying sector funds in emerging technologies. Solar power and self-driven cars may be great ideas but they may take years for such companies to deliver products and profits. You may just end up being too early. It is OK to miss the initial euphoria.
  3. When you bet on a trend, ensure that companies in the portfolio benefit. For example, if you are looking at commodity funds, steel has done better than aluminium or copper due to potential demand. Be clear which stocks in the portfolio will gain from the trend. Solar power may be a good idea but Power Grid may not be a big beneficiary.
  4. Distinguish between immediate beneficiaries and long-term beneficiaries. For example, in the Atma Nirbhar project, outsourcers like Amber Enterprises and Dixon Technologies may be immediate beneficiaries. However, companies like Bharat Electronics and BHEL may be long term beneficiaries. In any sector fund, keep a time frame of 7-8 years for the trend to fully play out.
  5. How long will P/E expansion take? If you buy a commodity metal fund, you just buy closer to the lower half of the cycle. However, technology and pharma funds are more complex. You get decent returns when the price grows with earnings but you get solid returns only when the P/E starts to expand. That is the target!
  6. Focus on fund selection. For example, the best performing technology fund gave 22.83% returns while worst performer gave 12.83%. That is a huge gap of 1000 basis points. One way is to stick to funds that are consistent top performers across time frames. Avoid funds the very small AUM.
  7. Focus on funds with low expense ratios since costs matter. Choose a Direct Plan instead of a Regular Plan to avoid paying marketing and distribution costs. Remember, when you save even 2% a year, it compounds to a substantial amount over 10 years.
  8. Check how the sector fund fits into your overall allocation. Technology funds may be a great idea but if you have 25% of your equity exposure in tech stocks, there is no point in adding more technology funds. What is good for you matters more than returns.
  9. This is tough to digest but invest only that portion of your portfolio in sector funds that you are willing to lose and can afford to lose. It normally does not happen that way, but it is just to underline that sector funds are high on risk.
  10. Crystallize a proper exit strategy. It could either be exiting at a loss or booking profits in the short term or booking profits in the long term. For example, if your sector fund has given 90% returns in 1 year, it makes sense to take money off the table. Also, when you are holding the fund for a goal and that goal is reached, just trigger your exit plan.
Sector funds are a great idea if you do your homework and limit it to a small portion of your overall equity exposure. That is the key.

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