Gold funds on average delivered around 22% return last year and banking sector funds focused on private sector banks and financial services companies delivered around 18% average return. This does seem more exciting than your standard large cap equity diversified fund return. Should you switch then to these higher performing categories? 

Before deciding that, also know that gold funds delivered roughly 3% return in 2017, -8% in 2015 and around -11.5% in 2013. Similarly, Banking sector funds delivered close to 0% returns in 2018 and roughly -8% return in 2015.

Sector themed and focused funds invest in one type of asset or in a narrow segment of the market, making these funds more vulnerable to sharp declines if things go wrong. Returns may be good, but risk is high too.

Such funds hold a cyclical return advantage but you should also know when to enter and exit. In case of gold funds, the category has given negative returns for three out of the last nine calendar years, 10% or lower return for another four and returns above 20% only in the remaining two years. 

The good and the bad

Such funds hold a cyclical return advantage but you should also know when to enter and exit. In case of gold funds, the category has given negative returns for three out of the last nine calendar years, 10% or lower return for another four and returns above 20% only in the remaining two years. 

In case of banking sector funds, returns have been negative in four calendar years since 2011, between 10%-15% in two and above 35% in the remaining three calendar years. Now, unless you know which are the good years in advance (which is impossible!), you may be in for a rude shock as the outperforming calendar years are usually followed by negative returns. 

Diversified equity funds on the other hand, don’t exhibit very high volatility, the choice of stocks from across sectors helps in maintaining consistent returns. For example, in the large cap category funds, there have been two calendar years of negative return since 2011 of which in one year the category average was -1%, 3 years of sub 10% positive return and 4 years of 10% plus return with the highest category average performance of 36% in 2014.

The fewer instances of negative returns and the limited drawdown at -1% in one out of the two years is not random. Diversification in funds helps in limiting losses resulting from cyclical factors which impact specific sectors. Moreover, in a sector fund you are likely to have very high exposure to individual stocks. For example, a banking sector exchange traded fund has 29% in HDFC Bank and 20% in ICICI Bank, hence, a lot of the return from the fund will depend on what these two stocks do. 

The entire idea of investing in a diversified fund to reduce risk is negated when it comes to sector funds as return outcomes are harder estimate. 

What should you do?

Have a balanced portfolio. If you already have good exposure to diversified funds only then should you entertain the idea of adding sector themes but that too only with limited surplus and an exit strategy in place. While you may want to include gold in your investment portfolio, don’t overload it, rather add only as much as required for creating an inflation hedge. 

Your overall investment portfolio should be aligned to your long-term financial objectives, for which high risk and uncertain return themes like sector funds are not useful. Diversified funds with a consistent track record are best suited for a long-term investment strategy given their ability to balance risk in the long run.