Mutual Funds: Investing in sectoral funds? Proceed with caution

An allocation of 5 -10% in the overall portfolio can be reasonable if you have the right risk appetite,” advises Chetanwala.

Given that most sectoral and thematic funds, particularly those belonging to technology and healthcare sectors, have outperformed the broader market (S&P BSE 500) by a fair margin since the lows of March 2020, such funds are gaining traction from mutual fund investors. The net assets under management of sectoral/thematic funds rose 79% to Rs 1.1 lakh crore in April this year from `56,800 crore in the same month last year as investors typically tend to chase recent performance.

What’s drawing investors?
After the outbreak of Covid-19 early last year, the stock markets witnessed significant drawdowns of around 40% on concerns over the economic impact. However, after announcements of massive fiscal and monetary stimulus across the globe, followed by optimism around vaccine discovery and roll-outs, equity markets bounced back sharply.

Harshad Chetanwala, co-founder, MyWealthGrowth.com, says some of the sectoral and thematic funds have done well in the last one year as the market correction in 2020 along with pandemic and lockdown helped a few sectors to perform better. “Many investors are looking at the short-term performance and want to add some of these funds in their portfolio. Hence, we continue to see constant interest of investors in sectoral funds at present. Sectors like pharma, information technology, banking and consumer discretionary continue to draw the attention of investors,” he says.

Similarly, Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says with the economy poised for a recovery having contracted 7.3% in FY21, cyclical sectors such as financials, industrials and basic materials are likely to do well as the economic recovery picks up steam. “However, given the uncertainty around the pandemic, it is best to stick to long-term asset allocation, and invest the core of their portfolio into well-diversified funds avoiding excess concentration in a single sector/theme,” he says.

What to look out for?
Investors must keep in mind certain factors before investing. Sectoral funds carry significantly higher risk as they bet on the performance of a single underlying sector. Performance of such funds is cyclical in nature, and is more volatile compared to funds diversified across sectors. Fund managers cannot protect the downside by moving away from the sector in case the outlook for the sector deteriorates.

Chetanwala says investors must keep in mind that there are different themes that may have potential at different points of time due to multiple factors. “Sometime, the theme could be infrastructure, consumption, energy, healthcare, etc. Most of these themes go through a cycle and may lack consistency over the long term. Hence, looking at the last one year return to invest in these funds is not advisable,” he says.

What should investors do?
Kapadia says investors should ideally limit exposure to such funds to less than 5-10% of the portfolio. “One should have a high degree of conviction before entering into such funds, and be ready to ride out the volatility and remain invested till the call plays out. One needs to be more nimble with sectoral funds and at times take exit calls either if one’s view has played out, i.e., the sector has outperformed the broader market and valuations appear too high or if the view has undergone a change,” he advises.

Investors must invest with a goal and sectoral/thematic should form a part of the portfolio based on the risk appetite. Brijesh Damodaran, managing partner, BellWether Associates LLP, says investors must look at the headwinds and tailwinds in the sector and catch the trend early, as in the pharma sector, which till mid-2019 was not in favour and started attracting attention slowly. “Today’s ecosystem is both fluid and volatile. One needs to consider the time horizon and the cash flow and liquidity needs before investing in thematic sectors. With that as the background, one must look at policies affecting the sectors and the trends,” he says.

Before investing in sectoral funds, look at the annual return and compare it with equity diversified funds. Chetanwala says these funds invest in limited companies and industries, hence the portfolio can be concentrated which can result in more risk. “Also, the fund has a mandate to always follow the theme or sector irrespective of right or wrong time to be invested in some of these companies and industries. The performance of sectoral funds can be very subjective and does have additional risk when compared with diversified funds,” he says.

Some sectors like IT, banking & financial services offer more consistency compared to others. “One should restrict allocation in thematic and sectoral funds as they carry more risk compared to equity diversified funds. An allocation of 5 -10% in the overall portfolio can be reasonable if you have the right risk appetite,” advises Chetanwala.