What Are Sectoral funds and Should you invest in them?
Sectoral funds are mutual funds that restrict their focus to shares in a sector. They are riskier and more volatile when compared to other mutual fund schemes since their focus is on a single sector which means less diversification and sector specific risks.
For example, Infrastructure sector funds will be highly sensitive to government action or Banking sector funds will be highly sensitive to Non-Performing Assets (NPAs). This has been the case in the recent months.
For any new investor without years of experience, sector funds are not recommended. Let us look at the past performance and risk adjusted return profile of sector funds in comparison to other high risk mutual funds:
Since sectoral funds are high-risk, we are going to compare them to small cap , multi cap & mid cap funds which also are high-risk funds. We will use Sharpe Ratio of each fund to compare risk adjusted return profile of funds.
Sharpe ratio is the average return earned more than the risk-free rate per unit of volatility or total risk.
A mutual fund with higher Sharpe Ratio is considered superior to a fund with a lower Sharpe Ratio.
A Sharpe Ratio of 0.77 as seen above for ICICI Prudential FMCG Fund means for every 1% higher volatility, the return will be only 0.77% higher.
Now let us analyse and compare the sector funds data with small cap and multi cap funds data:
- Looking at 5 years, the annualized return of Reliance small cap fund and L&T India Value fund is significantly higher than sector funds.
- Even the 5 year Sharpe ratio of the sector funds is considerably low when compared to the small cap and multi cap funds.
- Looking at last 3-year period, Reliance small cap fund has performed better than all sector funds while L&T India Value fund was beaten by Infrastructure and banking funds. However, the sharpe ratio of both Reliance Small Cap & L&T India Value is higher than that of all sector funds.
- In 2013, if you were looking to invest in sector funds then you might have been attracted to IT or Pharma sector. The subsequent performance of these sectors was underwhelming due to significant headwinds faced by the sector. For an average investor, it is very difficult to predict these.
- Investment in equity mutual funds should be made with at least 5 years horizon. Much can change within one sector which can lead to underperformance of a sectoral fund. Even a skilled fund manager will not be able to do much if restricted to a sector with significant headwinds and not allowed to switch to a sector with tailwinds. This is captured very well in Warren Buffet words-
“Good jockeys will do well on good horses, but not on broken-down”
Sectoral funds are meant for a sophisticated investor who can assess the structural movements in the particular sector. Sectoral funds are hyper sensitive to events such as government actions or regulatory changes so importance of timing the market is high. If you intend to invest in sectoral funds then you must study & research the sector well. On the other hand, even if you want to take high risk, you can go for small cap funds/mid cap funds/multi cap funds which have better risk adjusted performance than sector funds.
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