Sector mutual funds invest all their assets in a specific sector. They have the potential to give higher than benchmark returns. However, they are vulnerable to losses as well. They best suit investors with a good understanding of risk. The timing of investment in these funds is very important. Investors should know when to enter and when to exit the fund. Read to know if you should invest in sector mutual funds?
What are Sector Mutual Funds?
Sector mutual funds invest a minimum of 80% of their assets in a particular sector as per SEBI‘s guidelines. They focus on a specific sector like banking, healthcare, real estate, energy, etc. For example, a banking fund invests only in banking stocks. Sector mutual funds provide an opportunity for investors to invest in sectors that have a high potential to grow.
These mutual funds provide attractive returns but generally if the investment timing is precise. The timing of investment in sector-specific funds is vital. Also, the exit from the fund becomes crucial. This is because sectors follow the business cycle. The ups and downs of the cycle affect the fund. Choosing high growth sectors for investment can lead to potentially high returns. However, a downfall in the industry can lead to significant losses as well. It is mainly due to the lack of diversification.
All the assets are invested in one sector. Hence, the volatility of the fund tends to be high. Sector funds are a possible way to enhance a portfolio. However, one has to be patient enough to go through the market cycles.
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How do Sector Funds Work?
Sector Funds invest in a particular industrial sector. For every sector, there are many ETFs and mutual funds available. Each fund is different from the other. Each fund has a different set of holdings, despite them investing in the same industry.
Below are the unique features of sector funds:
Focused: Sector funds focus on one particular sector. Hence, they do not offer diversification. The performance of the fund is entirely dependent on that specific industry.
Period and Duration of Investment: Sector funds are for medium to long term. Short term investments become risky. Also, investments should be for a defined period. As sectors have a cyclic pattern. Once the investment reaches a peak, it’s wise to exit the investment. Therefore, for this, a thorough market analysis is required.
High Risk: Sector funds pertain to one particular industry and have no scope for diversification. Hence these funds are can be riskier than other mutual funds.
High Returns: If a sector is expected to perform well over a period of time, then it is possible that returns would be high.
Hedging: Sector funds can be a good hedging investment. In other words, a sector inversely proportional to the economy would be a perfect investment to hedge the portfolio.
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Who Should Invest in Sectoral Mutual Funds?
Sector mutual funds are not for every investor. They give huge returns but are also vulnerable to losses. These mutual funds have high volatility. Also, any inaccurate prediction of the market conditions and growth trend can lead to huge losses. Sector fund investment best suits investors with better understanding of risk. Investors with a horizon of 5-7 years or more can look at this investment.
In the words of Warren Buffet, “Never invest in a business you cannot understand.” Investors should invest in sector funds only if they understand and have confidence in a particular sector. They should understand the industry, the aim, and the theme of the fund. Only if the investor is confident enough that the sector will deliver positive results, he/she can consider investing in it. Ideally, not more than 10% of the portfolio should be allocated to a particular sector.
Things to Keep in Mind Before Investing in Sector Funds
You should know all the details of a sector before you invest in sector mutual funds. Keep in mind the following:
Fund Objective: Understand the fund objective thoroughly. For instance, few funds invest only 65% of the portfolio in the specified industry. As a result, this can dilute the sector exposure and shall not yield the estimated returns.
Time the market: Though it’s a famous saying that one cannot time the market. But, when it comes to sector funds, timing plays an important role. The performance of these depends on the economic cycle. An in-depth study of the sector would help in determining the stage. For example, the banking sector stocks perform well when the interest rates are expected to fall and vice versa. Therefore, to generate good returns from these funds, detailed research is required. Also, timing the market holds for both entry and exit of the investment.
First Diversify: Before investing in sector funds, it is always advised to have a diversified portfolio. It would help in minimizing the risk of exposure to just one sector. These funds should ideally be only 5%-15% of the investor’s portfolio.
Past Returns: Do not entirely depend on the past performance of the sector. Instead, identify the opportunities that would help the sector grow and invest in them.
High Risk: Sector funds are high-risk investment options. These funds have exposure to just one sector. Hence, making the investment highly dependent on the performance of that sector.
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Types of Sector Mutual Funds
- Technology: The technology sector invests in stocks of companies that offer technology-based services or produce technology products.
- Financials: Invests in financial stocks such as banks, brokerage firms, mutual fund companies, insurance companies, etc.
- Consumer Cyclical: Invests in companies that sell non-essentials. In other words, companies that sell goods that people don’t need for everyday living.
- Consumer Staples: This category is opposite to consumer cyclical. These are stocks of companies that sell goods for everyday use.
- Utilities: This sector invests in companies that provide products and services related to phones, electricity, and gas.
- Energy: The energy sector invests in industries producing and distributing energy.
- Natural Resources: Invest in commodity companies such as energy, minerals, chemicals, etc.
- Health Care: Focuses on the healthcare industry and invests in stocks of biomedical companies, hospital conglomerates, drug manufacturers, medical instrument makers, etc.
- Real Estate: Invests in real estate companies and REITs (real estate investment trusts).
- Precious Metals: These funds invest in precious metals mining companies.
Sector Mutual Funds Debriefed
Should you invest in sector mutual funds? Well, sector fund investment isn’t bad. Since sector MFs are highly focused funds, it is important to understand the sector in its entirety. However, you should also be willing to undertake the risk associated with it. Furthermore, you should also evaluate how much exposure to a sector is healthy for your investment portfolio. Also, diversified mutual funds often invest across sectors that are performing well, therefore you need not worry about missing out on a sector investment opportunity. These are a good alternative for pure sector schemes. To conclude, you should invest in sector funds only and only if you are well aware and able to predict a good cycle for that sector and are comfortable with its volatility.