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Sectoral mutual funds offer concentrated exposure to specific industries, potentially amplifying both returns and risks compared to broader market funds.
This article explores these funds’ intricacies to help you decide if they align with your investment strategy.
What are sectoral mutual funds?
Sectoral mutual funds are funds that invest primarily in stocks of companies belonging to a particular sector or industry. Unlike diversified mutual funds that spread investments across various sectors, sectoral funds concentrate on a specific area of the economy. For example, sectors such as technology, healthcare, banking, or infrastructure.
Sectoral mutual funds usually are:
- Focused – A significant portion (typically 80% or more) of their assets are invested in companies operating within the chosen sector.
- Actively or passively managed both – While some sectoral mutual funds could be actively rebalanced by a professional portfolio manager, others could just track sectoral indices passively.
Why use sectoral mutual funds?
The main reason why sectoral mutual funds are attractive to investors is because they have the potential for amplified returns. This happens when a certain sector is set to outperform the broader market.
For instance, the Nifty Pharma index delivered over 23% returns in 2023, compared to the Nifty 50’s 12% return.
It is because of this sector-focus that they’re also inherently more risky than other broader market funds. If the chosen sector underperforms, the fund can experience significant losses.
For example, the Nifty PSU Bank index declined by over 5% in 2023 compared to the Nifty 50.
Diversification, hence, plays a huge role even when you’re investing in multiple companies in the same sector.
Sectoral mutual funds are usually suitable for experienced investors who have a high risk tolerance and a long-term investment horizon (typically 5-10 years or more) who have a strong conviction about the future prospects of a particular sector.
Sectoral performance can sometimes also be influenced by regulatory changes, government policies, or sector-specific regulations.
For example, policy shifts in the healthcare sector regarding drug pricing or regulations can affect pharmaceutical sectoral funds entirely, but not the broader market in general.
Choosing a sectoral mutual fund
There’s a lot of work that goes into allocating cash to assets, but it also takes some work to choose a mutual fund that does that for you. Do not choose the first fund that pops up on your brokerage account. Here are some tips:
Know everything you can about the sector
Research the chosen sector’s growth drivers and future outlook. Analyse factors like technological advancements, government regulations, and global economic trends that might impact the sector’s trajectory. This will give you the best chance to understand what drives the sector, and what could potentially bring it down.
If you want to go a bit further than most people, you could also analyse the valuation of the companies within the sector. This is to avoid overpaying for companies already trading at a significant premium compared to their intrinsic value
Study the fund and compare it with others
Understand the fund’s investment philosophy. Does it focus on large-cap, mid-cap, or small-cap companies within the sector? Each segment carries varying risk-return profiles.
While you’re aware that sectoral funds inherently have less diversification, do not forget about the concentration level within the portfolio. Over-concentration in a few companies can amplify both potential gains and losses even within a specific sector.
Different funds also have different management fees. You should aim to strike a balance between the best-constructed fund and the lowest management fees.
Define your investment horizon
Be mindful of investment horizons when investing in a sector. Different sectors experience periods of boom and bust. Ensure your investment horizon aligns with the expected cycle of the chosen sector.
Frequently Asked Questions
Sectoral funds are generally not recommended for beginners due to their higher risk profile and requirement for in-depth sector knowledge. Beginners are better suited to diversified mutual funds that offer broader market exposure and lower risk.
Examples include ICICI Prudential Technology Fund (technology sector), SBI Healthcare Opportunities Fund (healthcare sector), HDFC Banking & Financial Services Fund (banking and financial sector), and Aditya Birla Sun Life Infrastructure Fund (infrastructure sector).
Both sectoral and thematic funds focus on specific themes or sectors. However, sectoral funds typically invest in companies belonging to a well-defined industry like technology or healthcare, while thematic funds may invest in companies across different sectors that share a common theme like clean energy or artificial intelligence.
Sectoral funds are treated as equity funds for tax purposes. Long-term capital gains exceeding Rs. 1 lakh are taxed at 10%, and short-term capital gains are taxed at your income tax slab rate.
Sectoral funds can be a part of a diversified portfolio for experienced investors seeking targeted exposure to high-growth sectors. However, they should not be the sole component of your portfolio due to their inherent risk.
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