Mutual funds that invest in a specific sector, such as information technology, pharmaceuticals, banking, etc. are called sector funds or sector-specific funds. These funds allow investors to take advantage of the growth potential of particular sectors of the economy. Sector funds differ from diversified funds that invest across sectors and industries. In recent years, sector-specific funds have become quite popular among investors in India looking to benefit from the high growth seen in sectors like IT, pharma, FMCG, banking, etc. However, sector funds also carry higher risks compared to diversified funds. 

Benefits of investing in sector funds

Focus on high growth sectors 

Sector funds are top mutual funds that channel investments into industries and sectors experiencing rapid growth. For instance, technology and pharma sector funds allow investors to benefit from India’s globally competitive IT and pharma industries. Investors can target investment in high potential areas of the economy.

Specialized research and expertise

Fund managers of sector-specific funds develop specialized knowledge and expertise about firms, trends, growth drivers and risks in that industry. Their research and stock selection are focused on a particular sector. This enables them to better identify winners in those sectors.

Benefit from sectoral trends

Sector funds allow investors to benefit from market cycles and macroeconomic trends favoring particular sectors. For example, infrastructure funds benefited from the past boom in infrastructure building in India. Sector funds can better capture upside from such trends.

Diversification within a sector

Though sector funds have concentrated exposure, they can provide diversification within a sector by investing across firms. For instance, a banking fund may invest across public and private banks to reduce company-specific risks.

Risks of investing in sector funds

Lack of diversification across sectors

The biggest risk in sector funds is lack of diversification. A pharmaceutical fund investing purely in pharma stocks can see high volatility if the sector goes through a downturn. In contrast, a diversified equity fund can contain downside risk through sector diversification.

Vulnerability to business cycles

Sector funds are vulnerable to business cycles that impact a particular industry, while other sectors may flourish. For example, an infrastructure fund will suffer if the infrastructure industry goes through a lean phase, irrespective of performance of other sectors.

Exposure to regulatory risks

Sectors such as banking, pharma, telecom, etc. face significant regulation and government policy changes. Sector funds focused on such industries are exposed to major regulatory risks that can adversely impact the business landscape. Diversified funds are less vulnerable to such sector-specific risks.

Lack of flexibility 

Sector funds have limited flexibility to invest outside their sector mandate. A diversified fund manager has the flexibility to shift across sectors based on changing market conditions. Sector fund managers have to stick to their sector even if the outlook turns negative.

Higher volatility

Due to lack of diversification and exposure to sector-specific risks, sector funds tend to be more volatile compared to diversified equity funds. The NAVs of sector funds fluctuate in a wider band compared to diversified funds.

Choosing the right sector funds

Analyze sector growth prospects

Evaluate the past performance and future growth potential of the sector. Avoid sectors with slowing growth, excess capacity, or unfavorable regulations. Prefer sectors with strong growth trends and favorable macro environment.

Assess fund manager expertise 

Examine the sector expertise and track record of the fund management team. The success of active sector funds is directly linked to the fund manager’s stock selection skills and understanding of the sector dynamics.

Consider market valuations

Sector funds carry higher risk when the overall market trades at expensive valuations. Historically, sector funds have delivered stronger returns from lower market valuations.

Diversify across sectors

Limit exposure to any single sector fund to 5-10% of the overall portfolio. Diversify across sector funds focused on industries with different growth cycles and risk profiles.

Have a long-term horizon 

Sector funds carry higher volatility in the short term. Have an investment horizon of at least 3-5 years when investing in sector funds. Avoid trying to time entry or exit based on short-term trends.

Conclusion

Sector funds offer opportunities to benefit from the high growth potential of India’s rising sectors. However, lack of diversification makes them risky as standalone investments. Limit sector fund exposure to a small portion of the overall portfolio and diversify across sectors. Adopt a long-term approach when investing in sector funds. Maintain robust risk management practices and consider SIP for disciplined investment.