Expert advice

Jul 08, 2013,13.18 IST

Should sector funds be a part of your portfolio?

Sector funds are highly focused as they aim to invest in a particular industry or a sector. Their basic objective is to allow investors to take advantage of industry cycles. Therefore, if the timing is right, sector funds have the potential to generate good returns. This is evident from the fact that over the last one year FMCG and Pharma funds have given an average return of 25 percent as against a rise of 15 percent in the BSE Sensex.

On the flip side, as sector funds have a narrow focus, they do not provide the downside risk protection available in a well diversified equity fund. It is quite common to see these funds perform exceptionally well during certain periods, but perform inconsistently during other times. A case in point here is the performance of banking sector funds over the last couple of years.

However, despite their volatile nature, sudden bursts of out-performance by sector funds often attracts the attention of retail investors. As a result, even those investors who intend to build a corpus through a systematic Investment Plan over time end up investing in them. In the process, they not only expose themselves to higher risk but also face the risk of portfolio drift.

Check out the performance of sector funds

The moot question, therefore, is whether sector funds should be a part of your portfolio or not. Considering that the key to long-term investment success is to create a portfolio that provides the right balance between risk and reward, you must keep your risk profile in mind and the mix of funds selected for the portfolio should reflect that. For example, if you are an inexperienced investor looking to invest for the long-term and earn consistent returns, your portfolio composition should be different from someone who is an aggressive investor and understands the nuances of stock market investing. Therefore, you should consider investing in sector funds only if you already have an adequately diversified portfolio of equity funds and the risk appetite to absorb extreme movements associated with sector funds.

As a thumb rule, for someone who has a decent exposure to equity funds and is quite conversant with the behavior of the equity market, around 5-10 percent of the equity portfolio can be invested in sector funds. The key, however, is to select the sectors carefully as these funds ride on industry cycle.

You can adopt different strategies to reduce the risks generally associated with investing in sector funds. One such strategy is to have small exposure to 3-4 sectors rather than having huge exposure in one sector. However, before investing in a sector fund you must assess certain key criteria that may be important to your profile. These are:

  • How diversified is your existing portfolio?
  • Assess your risk taking capacity and the temperament to tackle the volatile nature of sector funds.
  • Do you have the capacity to hold a sector fund for the long-term, if required and to curb the urge to switch frequently from one sector to another?
  • Are you willing to invest some time and effort to keep up with the industry developments in a chosen sector? This can be of a great help in case of sudden shift in market’s view on the sector you are invested in.
  • Ensure that you do not invest aggressively in a sector to which you may already have a sizeable exposure through other funds.

Evidently, sector funds are good for those investors who understand the sector, both in terms of its potential as well as the attendant risks, and seek diversification in that sector. In fact, sector funds can be quite useful for these investors as they can not only complement their existing stock’s portfolio but also enhance exposure to those sectors that may have under-representation in the portfolio.

Similarly, if you decide to exit from a sector and reinvest the proceeds into another, then sector funds can make things easier as they not only provide a readymade portfolio but also the flexibility to move the entire money among sectors fast.

To sum it up, sector funds can be a great addition to your portfolio provided you understand the pros and cons of investing in them. Remember, the key is to not to look at them with rose-coloured spectacles.

Hemant Rustagi
(The author is the CEO of Wiseinvest Advisors)

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