Most equity mutual fund schemes (including Equity Linked Savings Schemes) invest in a diversified portfolio of equity and equity related securities. By diversified portfolio, we mean that the portfolio comprises of stocks from multiple sectors and multiple stocks within a particular sector. Diversification reduces company and sector risks. As such diversified funds are suitable for investors who do not have sufficient knowledge of equity market risks. However, for more informed investors, who have some knowledge of equity markets, sectoral funds can be attractive investment options.
Unlike diversified equity mutual funds, sectoral mutual funds invest in particular sector. Within a particular sector, they invest in multiple companies as per the investment strategy of the fund manager. Therefore, while the company concentration risk is diversified, sectoral funds are subject to sector risk along with market risk. There are several sectoral fund categories. Some sectoral funds invest only in bank stocks. Some sectoral funds invest in Pharmaceutical stocks. Some sectoral funds invest only in technology stocks. Some sectoral funds invest in Fast Moving Consumer Goods (FMCG) stocks. Some sectoral funds invest in Infrastructure stocks. See the performance of various sectors here –
Different sectors outperform each other at different parts of the economic cycle of a country. For example, cyclical sectors (like bank, infrastructure etc) outperform defensive sectors (like Pharmaceuticals, FMCG etc) when economic (GDP) growth outlook is optimistic or in bull markets. On the other hand, defensive sectors outperform cyclical sectors when economic growth outlook is pessimistic or in bear markets.
Infrastructure sector stocks tend to perform very well in the early stages of market recovery from a bear market. Bank stocks perform well after interest rates have peaked and a declining interest rate regime is expected. Defensive sectors like Pharmaceuticals and FMCG tend to perform well in all market cycles, though they tend to underperform cyclical sectors in bull markets. Outlook of export oriented sectors like pharmaceuticals, technology etc are greatly influenced by global macro-economic outlook and foreign exchange rates. If global macro-economic outlook is favourable, export oriented sectors perform well and vice versa.
Unlike diversified equity mutual funds, where market timing is irrelevant if the investor has a long investment horizon, investing in sectoral funds may require the investor to time his or her entry or exit in the fund because in the long run, some sectors will outperform the broader market, while some sectors will underperform. You may have to contend with returns lower than your expectations, if you unfortunately invest in an underperforming sector. On the other hand, by investing in the right sectoral fund at the right time, you can have terrific returns, much higher than what you may have expected.
Investing in sectoral funds is more difficult than investing in diversified equity mutual funds, because you have to identify both the right sector and then the right scheme within that sector. Sectoral mutual fund investments require some market knowledge, especially understanding of sector risks, which average retail investors do not possess. Experienced financial advisors can help investors identify the right sectoral funds to meet their investment objectives.
Sectoral mutual funds should not form your core investment portfolio. However, smart investors allocate a small portion of their portfolio to sectoral funds and rotate sectors from time to time, to enhance their overall portfolio returns.
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