Gaurav works in the treasury department of a leading private bank. He believes that the interest rates are headed downwards and there will be huge gains in the bond portfolio of banks. He expects that these gains to reflect in the prices of banking stocks in the medium term but he is not sure which banking stock to invest in. He starts a systematic investment plan (SIP) to invest in a banking sector fund. Sector funds are those mutual fund schemes that invest only in stocks of a particular industry or sector. For instance, banking funds invest in stocks of banks and financial institutions. FMCG and pharma funds invest in stocks of FMCG and pharmaceutical companies respectively. So, rather than going with a single stock, Gaurav has chosen to go for a bouquet of stocks in the same sector.
To an extent, Gaurav is right. There are advantages to investing in a sector fund. A banking sector mutual fund scheme can help him to:
- Diversify risk within the sector: By investing in a sector fund, you do diversify risk among the stocks in the same sector. A specific stock may suffer or perform badly due to a company specific development but the other stocks in the same sector will provide the cushion.
- Use fund manager expertise: A fund manager, using the research resources at his disposal, is more likely to choose the best stocks in a sector than an average investor.
- Outperform the broader markets: If your conviction and research about a sector is right, you do stand to reap better than market profits. Let’s look at how various sectoral indices have fared over various periods vis-a-vis CNX Nifty. The comparison is as on December 31, 2014 As you can see, CNX Bank, CNX FMCG and CNX Pharma have outperformed broader markets (CNX Nifty) significantly over all the terms while CNX Metal and CNX Realty have underperformed over all the terms. Hence sectoral bets, if you get them right, can give you handsome returns.
Should you invest in sector funds?
We are sure you have such convictions too about the sectors you work in. Then, should you invest in sector mutual funds too? Not so soon. The outperformance of CNX Bank, CNX FMCG and CNX Pharma is just one half of the picture. The performance of CNX Metal and CNX Realty indices shows what can happen if your conviction goes wrong. Let’s list out a few other issues with investing in sector specific funds.
- Timing the market: To grow wealth in stock markets, time in the market is more important than timing the market. Unfortunately, to make money in the sector funds, you may have to learn to time the market especially in the cyclical sectors such as banks, cement , steel etc. For example, banks (or banking stocks) outperform when the interest rates are low or are expected to fall and underperform when the interest rates are rising. So, to invest in a banking fund, you have to be at the right turn of the interest rate cycle to outperform broader markets. Though you must choose the SIP route to build exposure to such funds, you must close those SIPs and exit position in the sector funds when the sector fundamentals begin to deteriorate.
- Low diversification: Sudden adverse development in a particular sector will hit all the funds investing in stocks in that sector. However, the sector funds (that invest solely in stocks in that particular sector) will be hit the hardest. In an equity diversified fund, you would have stocks from other sectors to soften the hit.
- Equity diversified funds give a decent exposure: Fund managers of the diversified funds increase allocation to sectors that are expected to do well in the near future. Over the last year, it was expected that interest rates would fall and ground economy would improve. Banking stocks were likely to be the earliest and the biggest beneficiaries. Hence, equity diversified increased their exposure to banking stocks. HDFC Large Cap Fund, a large cap equity diversified fund, increased its weightage to banking stocks from 25.6% (as on December 31, 2013) to 35.2% (as on December 31, 2014). Hence, even by taking a position in an equity diversified fund, you are taking a higher allocation (than the benchmark index) to the banking sector. The weightage of the banking (and other financial institution) stocks is approximately 30%. Even by investing in an index fund (tracking CNX Nifty), 30% of your funds will get invested banking stocks.
- Finding good companies in a single sector is not easy: A mutual fund typically invests in atleast 15 to 20 stocks. Finding these many good companies in a single sector is not easy. For example, the incumbent central government is expected to give a strong push to infrastructure and housing sectors. This may make you bullish about companies in construction, engineering and real estate. However, if you are asked to name a few listed companies with excellent balance sheet and high standards of corporate governance in construction, engineering and real estate, you would struggle to name even five. The fund mandate does not allow much leeway to the fund manager and pick stocks outside the specific sector. Hence, by choosing to invest with sector funds, you may be betting your money on stocks on low quality companies.
- Correlation: If you work with a software company, you salary, future salary hikes and job security are linked to performance of the IT sector. If you concentrate your investment too in the technology sector funds, you are taking higher risk since your salary and investments are correlated with the performance of the IT sector. A slowdown in the IT sector will be a double whammy.
Considering both pros and cons of investing with sector funds, we suggest that the equity diversified funds are the way to go. However, if you have strong knowledge about a particular sector through professional experience or otherwise and can judge the impact of various events or government policies on stocks in that particular sector, then it may not be exactly unwise to invest in sector funds. However, investing in sector funds is akin to investing in stocks. You invest in such funds only till the time fundamentals of that particular sector are good. You exit your position as soon as sector fundamentals begin to deteriorate. Hence, though you should still take the SIP route to invest in sector funds, SIPs should be closed as soon as sector fundamentals begin to deteriorate or the industry cycle starts to turn for the worse. Under equity diversified funds, you continue with your SIPs to get the advantage of rupee cost averaging. Keep the following suggestions in mind while investing in sector funds:
- Invest only in those sectors where you have strong background knowledge
- Total allocation to sector funds shall not exceed more than 10% of your total equity portfolio
- Monitor sector fundamentals. Exit your position if the fundamentals have worsened.
Deepesh is Founder, PersonalFinancePlan.in