Strategies To Invest In Sector Funds

Investing in sector funds can be a double-edged sword, while it helps you to increase your portfolio returns, it may also inflict irreparable damage. DSIJ explains simple strategies that you can adopt to get superior returns. 

The recent stock market activity highlighted the fact that even the most protected citadel can fall apart. Even the best of the NBFCs, which remained one of the best wealth-creating companies in the last few years, is now seeing a precipitous fall. This is not unusual in the stock market. Business goes through various cycles as it expands, slows down and declines. We have witnessed this happening earlier in the Indian stock market and elsewhere. For example, between 2008 and 2015, pharmaceutical was the best sector that created wealth for its investors, but it is lagging now in terms of performance.



Although, business cycle has its own logic, investors who understand the business cycle can benefit out of it by taking appropriate position in their portfolios for better returns. There are various ways in which a sector-based strategy can be used to construct a portfolio and there are number of investment vehicles that can help accomplish this objective. Earlier, one of the most preferred way to gain exposure to a sector was to buy the stocks of many companies from that sector. Nevertheless, now you can invest in sector-based mutual funds to gain exposure to the entire segments of the market. These investment vehicles enable you to gain the desired sector allocations without having to invest large amounts of capital. Besides, they also help you to more easily execute a sector rotation strategy and tactically adjust your equity portfolios in order to increase exposures to sectors you feel have the best return potential.

Sector Funds In India

Sector funds in India are those funds that invest minimum 80% of its total assets in equity and equity-related instruments of a particular sector. Currently, there are four major sectoral funds available in India, viz. banking, infrastructure, information technology and pharmaceutical.



There are 54 funds in these sectors which together manage around Rs. 50,000 crore of assets. This forms only seven per cent of the total equity AUMs. The banking sector seems to be dominant, with more than half of the AUMs cornered by this sector, followed by the infra sector.



Here's a brief description of these four sectoral funds and where they invest.

Technology : The technology sector is a category of equity sector fund that invests in companies that are involved in technological businesses, such as computer software, computer hardware, or electronics & technological service industry companies, such as those providing information technology, etc. Companies ranging from Infosys, Wipro, TCS to Bharti Airtel form part of these sector funds. In the last one year, these funds have generated return of five per cent, however, the SIP returns is 3.4 per cent.



Financial : These sector funds will hold stocks of companies like ICICI Bank, HDFC, Bajaj Finance and LIC Housing Finance. These funds hold stocks that can include more than just banks and housing finance companies. These can also include insurance companies, asset management companies and credit rating companies.



Infra : The sectoral funds that are categorised as infra funds not only invest in infrastructure, but these go a little bit further to the suppliers of infrastructure creation like capital goods supplier, cement companies, steel companies, financing companies etc. Therefore, you can find companies such as HDFC Bank and JK Cement Limited in these funds, beside the obvious ones such as L&T and Ashoka Buildcon.



Pharma : These funds can cover any company that is engaged in the healthcare industry, which can include hospital conglomerates, insurance companies, drug manufacturers, biomedical companies. They also invest in diagnostic companies and biotechnology companies.



Performance of Sector Funds

Every part of the business cycle generates its own winners and losers. Individual investors can exploit this opportunity by allocating capital by sectors because that is how smart investors invest. It makes sense when you think about it because different sectors and set of companies do well in different business environments. Even when the economy is slowing, certain sectors tend to outperform, such as defensives.

The graph below clearly shows how different sectoral funds have performed over the years. We have taken the average returns of sectoral funds to arrive at annual returns. For example, in the year 2009, there were five funds that were dedicated to the finance sector, which on an average generated 76.11 per cent. The interesting part of these return figure is that not once has the same sectoral fund become the top performer next year. Every year, a different winner has emerged. For example, pharmaceutical sector, which generated the best returns in year 2015, remained the worst performer in the following year (2016).



Sector investment strategies means finding the best sector to invest in the forthcoming year. Investing in sector funds can generate better returns if you could identify the future winners among the sectoral funds.

The graph shows your return if you would have been investing in the best sector of that year and earning average return of that sector. (Annual Performance of Sectoral Funds)




Identifying the next winner

Nonetheless, the problem is identifying the sector that is going to perform next year. Here are couple of ways in which you can identify the sectors that can generate superior returns next year.

First, the above table (Annual Performance of Sectoral Funds) clearly shows that no single sectoral fund has been the best performer for two consecutive years. Hence, you should avoid investing in those sector funds that were top performers of the previous year. For example, tech funds that were the top performer of the year 2018 may not rank number one next year and hence should be avoided. We can already see certain headwinds such as appreciating rupee adversely impacting the tech funds.

What is also observed from the above table is that the sectoral funds have also not given two years of consecutive negative returns. Looking at year 2018 returns, except for tech funds, all other sectoral funds have generated negative returns. So, which are the best sectoral funds to invest now? Looking purely at the numbers above, we see that the infrastructure sector has a better chance. This is also corroborated by the fact that in the previous election years, such as in 2014, infrastructure funds were the best performers.Moreover, in the year 2018, these funds were the worst performer.

To dig deeper into this, we thought that institutional investors who are better equipped than a common investor might give us the indication where they are increasing their holdings. For this, we studied where mutual funds are increasing their stakes. The SEBI data shows that in the last six months ending May 2019, MFs have collectively increased their stake highest in banks. In the last six months, their stake has increased from 21.85% to 24.46%. It is followed by consumer durables, petroleum products and cements. If we analyse the top 10 sectors where there is maximum inflow of funds, it looks like infrastructure is going to generate better returns going ahead.



Strategy
In addition to this, you can also apply a simple strategy of 'revision to mean'. This means investing in sectoral funds that have performed worst last year and may turn out to be the best performer this year. Hence, you identify the worst performing sector of this year and invest in the sector at the start of the next year. We see this 'strategy' generating returns superior to most of the sectoral funds. Since the start of the year 2009 till the end of 2018, the strategy has generated returns better than most of the 'sectoral funds', including frontline indices like 'Nifty 50'.



Investing in a sector funds can be a risky proposition as the investment is very much concentrated. These funds invest in companies belonging to that particular sector only and are, therefore, more volatile than other sectors. Hence, a sector fund should never be your core fund which you hold for the long term. It can be a part of your satellite fund, where you do tactical allocation. Moreover, it should never constitute more than 10% of your total portfolio. A sectoral fund can juice up your returns, however, it is best suited for investors having high risk appetite.

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