Indulge in sector funds, cautiously

The lure of better returns has generated investors' interest in sector funds. Investment managers are getting repeated requests from clients to increase allocation to sector funds as banking or fast moving consumer goods.

Sector funds such as pharmaceuticals, banking and technology have given far better returns than the Sensex (65.58 per cent) or the Nifty (64.76 per cent) in the past one year.

On the other hand, returns from the above mentioned category of sector funds have been quite impressive. The average annual return of the five technology funds is 72.31 per cent.

The FMCG category, comprising just three funds, has given a return of 61.92 per cent. The banking sector, having seven banking funds, recorded an annual average return of 74.22 per cent and pharma funds have given the highest return among the sector funds at 82 per cent.

"Sector funds are for aggressive investors. Each sector has its own business cycle and they tend to do well under certain market conditions," said Lovaii Navlakhi, a certified financial planner, who also runs the investment advisory outfit, International Money Matters.

But he cautions that the sector play should be carefully selected. Over the long term, the returns from these funds even out and cannot match up to the performance of diversified equity funds, according to him.

High risk, high return

Sector funds' performance is linked to the fortune of the sector. If the sector is doing really well, they outperform the market for that period. The contrary too holds true.

Take, for example, Reliance Pharma fund. The fund has returned 102.63 per cent in the past one year. In the last five years, this fund has particularly done well, especially after the market crash of 2008.

The reason being investors look for defensive sectors to park their money in a falling market. If the returns from this fund are compared to the broader indices in 2005, 2006 and 2007, it has underperformed the Nifty consistently.

Let's look at the dynamics of each sector and how it affects the performance of the funds.

Banking: Stocks in this sector perform well when there is an overall growth in the economy. "Economic growth results in an increase in corporate credit offtake. Also, the retail loan segment does well in a growing economy as people tend to borrow more to finance their home, car and so on," said a chief investment officer of a mutual fund. This is also the most popular sectoral fund category with seven retail funds and four exchange-traded funds.

But the stocks also suffer when the Reserve Bank of India's policies are perceived to slow down banks' business.

FMCG and pharma: These are defensive sectors. These sectors, hence, tend to do well in a falling market. This is based on a perception that companies in this sector will continue to do business, even if the economy is not doing good.

In the past one year, these sectors have also attracted attention as the government has cut duties to boost domestic consumption.

But pharma stocks are sensitive to regulations. If any regulation from the ministry of chemicals and fertilisers or the National Pharmaceutical Pricing Authority is perceived as negative, the performance of these funds suffers. For pharma companies having businesses abroad, the changes in regulation in the country of their business too affect them.

FMCG stocks, on the other hand, see their valuations coming down when inflation is on a rise. "Rising inflation means higher input cost. This affects margins of FMCG companies," said a fund manager of an FMCG fund.

Technology: When the information technology sector was hot in 1998, there were more funds than the current five. Some of them were merged with other funds or fund houses added themes (such as services) to include more sectors.

Their performance depend on the economic conditions of developed countries, especially the US, and dollar movement.

This is why tech stocks, as they are commonly addressed, have seen a spurt in valuations when some data suggested that the US economy may come out of recession. The expectation that the dollar will depreciate in future has added to the rising prices of tech stocks, and tech funds in return.

Taking bets

Investment advisors, usually, do not recommend sector funds to lay investors. "It is only for the people who are well-versed with the stock market and understand the sector," said Brijesh Dalmia, director, Dalmia Advisory Services.

For lay investors, a diversified equity mutual fund is more suitable. "These funds, typically, will have some exposure to all sectors, especially the one that is doing well on the stock market," said, Rajat Jain, chief investment advisor at Principal PNB Asset Management Company.

Financial planners, hence, suggest that even informed and aggressive investors should restrict their sector-based investments to a maximum of 10 per cent of their total investment. The tenure too should be at least two-three years to average out the returns. "No one can time the perfect entry and exit in a sector fund," said Navlakhi.