Sectoral risk and reward

Investing in diversified equity funds with a good track record can solve the problem of sectoral diversification

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Sectoral risk and reward

Of all the types of diversification problems that we have discussed, sectoral diversification is the hardest to tackle, simply because the correct mix is the hardest to figure out. Of course, it will be very obvious to every reader what sectoral diversification is -- one shouldn't have too much exposure to one sector. However, there are two attendant problems. One, how much is too much? Also, one wonders about the other side of the spectrum. How little is too little?

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The answer to these questions may surprise you. Ideally speaking, sectoral diversification is not your problem at all. You should be investing in well-chosen diversified equity funds with a good track record and that's that. Once you have done that, you shouldn't bother about whether 30 per cent of your funds are in financial services companies or 10 per cent is in infrastructure. You invest in a mutual fund so that such decisions can be off-loaded to the fund manager. Sectoral allocation is fundamentally different from say, asset class diversification. How much equity should your portfolio have is a decision that you have to take based on your own needs. But which sector that equity should come from is your fund manager(s)' decision based on his or her judgement of where the market is going.

As an indicator on how a fund allocates across sectors, one can look at the fund's allocation to different sectors during different phases of the economic cycle. The fund manager's experience and expertise will come in handy to address the sectoral allocation, which they deftly manage.

So why are we discussing about this at all? There are two reasons. One, the scourge of sector and theme funds and two, direct equity investments. Even though they are in a Sebi-enforced retreat nowadays, sector and thematic funds have been very actively sold in the past. So much so that those who have invested in specific periods when a sector was the flavour of the day have ruinously high exposure to specific sectors.

Take for instance, if you were investing in new mutual funds in 2006-2007, it is likely that you had a lot of money in the infrastructure sector. Before that, at the turn of the millennium 1999-2001 there was the technology phase and so on. Because they have a feature-driven identity, some investors are attracted to them. They start betting on a sector aggressively before realising the high allocation that they have in a single sector.

Besides sectoral funds, the other issue is that many fund investors also buy stocks directly. These can skew their sectoral allocation. In terms of tracking, this is not a problem because ValueResearchOnline can track equity investments too. Our Portfolio Manager can show you where you stand. Go to the Analysis tab in Portfolio Manager and scroll down to the Top Sector Weightage section (click on the image below). This will tell you which sector has what percentage and how much amount.

But really, this doesn't completely solve the problem. What is a high allocation and what is a low one? There's no fixed answer to this issue but one good rule of thumb is that no sector should be more than 30-35 per cent and the top three sectors should not add up to more than about 50-60 per cent. To give yourself an idea of where the markets are, you could also take a look at the sectoral allocations of leading funds and indices. This could act as a reference for you to evaluate the sectoral allocation of your portfolio.

This story is a part of our previous report about advantages of having a diversified portfolio.


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