Sector and thematic funds invest only within a limited segment of the market. Exercise greater caution when investing in them
02-Mar-2011 •Research Desk
The argument for sector and thematic funds gets strong when you look at the 10 top-performing funds of the past one year — all of them are sector or thematic funds. The case gets stronger when you look at the 10 best-performing funds over a three-year period — eight of them are sector or thematic funds. However, a closer look at the performance of these funds also emphasises the fact that timing is of utmost importance when investing in them. For instance, Reliance Banking Fund has had a stupendous run since the market lows since October 2008.
Most investors are familiar with the concept of sector funds. Such funds invest in specific sectors like banking, pharma, FMCG and so on. Irrespective of the fund manager’s outlook on the sector, the fund remains invested in companies belonging to that sector. It is for the investor to decide when he should enter these schemes (when the sector outlook is bright), and when he should exit them (when its outlook turns negative). It is tough to get the timing consistently right. Therefore, investors need to be very sure about the dynamics of the sector before investing in such a fund.
Thematic funds invest in themes such as infrastructure, capex, opportunities and so on. They do not restrict themselves to any particular sector, but create a portfolio from all the companies that will benefit from the particular theme. Compared to sector funds, these funds are more diversified. For instance, PSU funds are thematic funds: these funds invest in PSU stocks which are expected to gain in value on account of the government’s disinvestment programme. Infrastructure is another important theme that may do well because of the humongous investments that the government plans to make in the country’s infrastructure. Again, as in the case of sector funds, so also in the case of thematic funds, timing of entry and exit is important.
Who should invest?
In case of a diversified fund, it is the fund manager who takes the calls regarding when to enter or exit a particular theme or sector, based on its outlook. However, this job is left to the investor. When you invest in a sector or thematic fund, you are trying to ride market cycles. These funds are essentially for investors who have a high risk appetite. Given the growth potential of certain sectors and themes in the market, investors may take a small exposure to these funds. While their return potential is high, so is their potential risk. If you get the timing of entry or exit wrong, you could end up performing worse than an investor in a diversified equity fund.
It is on account of these risks that thematic or sector funds are not for investors who are new to investing. These funds should never be the first funds that you add to your portfolio. They are for seasoned investors who have a diversified portfolio and are willing to allocate a small portion to these funds in order to augment their returns. Such investors should be aware of the risks posed by these funds. They should actively manage their portfolios, track the sector’s performance, and take decisions on entry and exit. In the process, they must be willing to take on more volatility in returns (than in the case of diversified equity funds). Thus, these funds live up to the adage: high risk and high returns.
Investors with a well-diversified portfolio and experience in investing may consider allocating up to 10 per cent of their portfolio into funds belonging to these two categories. Moreover, unless a particular sector or theme is doing very well and its long-term growth prospects look bright, it is advisable to not invest in these two categories of funds.
Also remember that a long-term investment horizon may not be suited for sector or thematic funds. While sectors move in cycles, themes are like fashion fads that emerge and have a small shelf life.
Investors, who because of their professional affiliation, have very good knowledge of a particular sector or theme, may consider investing in these funds. Because of their unusual insight and in-depth knowledge, they have the ability to be able to ride the upside potential of these funds. For instance, a person who works in a refinery may have a good knowledge of the prospects of the oil sector. A doctor may have good insider knowledge of the prospects of the pharma industry, and so on.
Building your portfolio
First, the core of your portfolio should comprise large-cap, large- and mid-cap and even mid- and small-cap funds. Only then should you think of adding thematic or sector funds. One reason for adding such funds is that they give you exposure to a new idea. For instance, international funds give you exposure to growth in foreign markets, so some exposure to, say, a China fund may be justifiable.
Before you invest in a sector fund, you need to analyse what exposure you already have to this sector via your diversified equity funds. For instance, if you feel that banking is an important sector which will grow over the long term in tandem with the growth in the Indian economy, and you find that you are underexposed to this important sector via the diversified equity funds in your portfolio, then investing in a banking sector fund may be worthwhile. The mistake to avoid is to invest in a sector (via a sector fund) where you already have adequate exposure through the diversified equity funds in your portfolio. Also, remember that many of these sector funds go out of favour when a cycle ends and a new cycle begins. Hence, you need to track the prospects of these sectors or themes, and regularly book profits in them as soon as you realise that a particular theme or sector has had its run.
IT, as a theme, had a great run in 2006. However, in 2007, it lost out despite the rest of the market having a great bull run. Investors should, therefore, be adept at taking calls to book profits, move across sectors and themes without getting emotional about their holdings. Unlike core funds where systematic investment plans and regular investing are recommended, lump-sum investments often work better in thematic and sector funds. Since timing the investment is not easy, one may consider a short-term SIP over six months to a year to ride on a theme or sector.
Mind your Ps and Qs
As these funds are exposed to one particular sector or a cluster of sectors, they have high concentration of risk. Hence, many such funds hardly provide the necessary diversification that a retail investor should look for. For instance, if the sector or the theme is in flavour, it can outperform the diversified fund as well as the index. On the flip side, an investor’s capital can also erode faster in such a fund than in a diversified fund. As usual, there’s a caveat to investing in these funds: past performance is no guarantee for of returns.