How to invest in sector and thematic funds?

Since August 2020, a total of Rs19,030cr flowed into sectoral and thematic funds and has been a big driver of positive flows into equity funds.

Aug 26, 2021 08:08 IST India Infoline News Service

In the last few months, flows into equity funds have been continuously robust. One star performer has been the sectoral funds. If you look at recent NFO (new fund offerings) from mutual funds, most of them are either flexi-cap funds or sectoral funds. 
Data Source: AMFI

Since August 2020, a total of Rs19,030cr flowed into sectoral and thematic funds and has been a big driver of positive flows into equity funds. In last 1 year, barring a couple of months, the net flows have been positive into sectoral funds. What triggered this interest?

Sector funds gained from post-pandemic recovery

One reason for interest in sector funds is the sharpness of post-pandemic recovery. Most sector fund categories like technology, pharma and financial services did extremely well. IT funds gained from faster IT adoption and global rise in tech spending. Pharma funds got a serious re-look post the pandemic. Financial services funds were an India proxy.

Most sectors saw deep correction during  the pandemic and the oversold situation gave the base to outperform. Sector funds were not impacted by broad-based laggards, which was the problem with many diversified large cap funds. Current SEBI rules only permit multiple sector funds, while other categories can have only one fund. That has driven the recent surge in sector fund NFOs.

But sector funds face some stiff challenges

For those enticed by the allure of sector fund returns, there are 3 important factors to be cautious about.

1) Pharma and technology funds may look great in retrospect. The real challenge in sector funds is identifying the right theme at the right time. That entails a substantial risk component and also an element of timing.

2) Identifying the theme is one side of the story, the bigger challenge is getting into the right sectoral funds. Even if you decide that technology is your preferred theme, there are a host of technology funds and performance divergence over last 1 year is huge.

3) The third challenge is to monitor your overall sector exposure. You may be holding TCS and Infosys in equities. If you binge on IT sector funds, your effective exposure to many of these stocks may go up to risky levels. That is something to monitor.

Is there a solution to this challenge in sector funds?

That brings us back to the core questions. Should you invest in sector funds at all? If so, how do you select which funds to buy and which funds not to buy? There are no hard and fast rules but you should ideally use a 2-step approach to making a decision on investing in sectoral or thematic funds. The first step pertains to an asset allocation approach. The second approach is the calibrated use of past returns data to take a view.

Step 1: Using the good old asset allocation approach

This may actually sound hackneyed but remains your best bet to approach how and when to invest in sector funds. You must look at sector funds as a subset of your overall equity fund exposure. The golden rule to follow is to not expose more than 20% of your overall equity exposure to sector funds. The remaining 80% should be in diversified funds so that the net concentration risk is regulated.

Once the asset allocation for sector / thematic funds diverges significantly from your original allocation, leave aside your view on the sector. Just liquidate profits and reallocate the gains to other funds so that the allocation to sector funds and thematic funds remain under check. This passive approach works best. This approach may sound boring, but it is still the safest way to play the investment game.

Step 2: Making smart use of past returns to select funds

Let us understand this by illustrating top performers in Technology Funds and Healthcare Funds over different time frames.
Technology Funds 1-Year Returns 3-Year Returns 5-Year Returns
ICICI Pru Tech Fund (G) 105.39% 36.28% 30.27%
Birla Digital India (G) 90.83% 33.82% 29.44%
Tata Digital India (G) 98.66% 31.72% 29.07%

Irrespective of whether you consider 1-year returns, 3-year returns or 5-year returns, the top three to four players are the same. These are not just outperformers but also consistent. When you select a sectoral fund, remember to focus more on consistency than on returns. One way is to check the yearly returns each month to measure consistency. Now for healthcare funds!
Healthcare Funds 1-Year Returns 3-Year Returns 5-Year Returns
Nippon Pharma Fund (G) 36.59% 24.64% 16.39%
Tata Pharma Fund (G) 34.34% 23.11% 12.83%
UTI Healthcare Fund (G) 30.68% 21.10% 11.97%

Data Source: Morningstar

Like in Technology funds, the top performers in healthcare funds have also been consistent across different time frames.

The moral of the story is that you can invest in sectoral and thematic funds provided you maintain allocation discipline and assess cues from past returns properly. Catching any sector at the bottom and exiting at the top never really happens in reality.

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