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4 Reasons To Avoid Sector Specific Mutual Funds

4 Reasons To Avoid Sector Specific Mutual Funds

Sectoral funds are mutual funds that invest in a particular industry sector or a theme. Examples are “Pharma” fund, “FMCG” fund, “Banking Fund”. A sectoral theme could be “GST” which invests in stocks that might benefit from the Goods & Service Tax implementation. Sectoral funds are a good way to take exposure in a particular industry without worrying about which specific stock to invest in. However, one needs to be wary of the risk they impose by being concentrated in a particular set of stocks with very limited flexibility.

Why Sectoral funds

Asset Management Companies (AMCs) come up with various themes of investment and there are several types of mutual fund schemes. Recently, SEBI issued guidelines to the AMCs to simplify the number of schemes they need to run. This is in the interest of the investor who might get confused with so many options out there.

From an AMC perspective, this is similar to an FMCG company coming up with different variants of their product(s), to meet the specific requirements of its customers. For example, a bath soap making company may produce different types of soaps, some of them appealing to the health-conscious, some claiming to treat the skin softly, some providing the beneficial effects of a key ingredient, while some may simply talk about freshness.

Similarly, mutual funds have launched various schemes with different investment philosophies. There are equity funds, debt funds, gold funds, balanced funds, etc. Within equity, we have large-cap funds, mid-cap and small-cap funds, multi-cap funds, etc. Each of these investment themes appeals to certain types of investors. Thus, mutual funds provide a lot of flexibility to the investor to align his/her investment objectives with the investment philosophy of the fund.

Sectoral funds are one more such ‘type’ of mutual funds and they help the investor get into a specific sector without worrying too much about specific companies and tracking their performance.

Why not invest in sectoral funds

On the face of it, Sectoral funds look like a good investment option. However, the following aspects need to be carefully understood.

1. Lack of Diversification
2. Lack of Flexibility
3. The investor has to make hard decisions (which sector, when)
4. Higher Expense Ratio

1. Lack of Diversification:

A Sectoral fund, by definition, is a fund whose investments are concentrated in one industry. For example, a pharma fund will invest only in shares of pharma companies. Thus, the fortunes of the fund are tied to the fortunes of that industry. If there is any negative development that adversely affects the industry, then it is all downhill for the sectoral fund.

2. Lack of Flexibility

Any investor will understand that his or her investments can be adversely impacted if there is any news flow that negatively impacts the investment. For example, a tire manufacturer will be adversely impacted if there is a rise in the price of rubber. The advantage of investing through the mutual fund route is that we get the benefit of a professional manager. Such a professional should be able to foresee likely problems and exit from investments that will get impacted. In our example, the fund manager will sell the stocks that can be negatively impacted due to a probable increase in the price of rubber. The money obtained from the sale of such shares would be used to buy shares of other companies.

However, the fund manager of a sectoral fund suffers from a certain disadvantage. Assuming that the fund manager is good and has been able to foresee the likely fall in share prices, he or she can surely sell what is currently held but lacks the flexibility of buying something else. The investment mandate is to invest only in shares of companies belonging to that sector. The fund manager will have to either hold cash or continue to invest in shares of some stock of that industry. To that extent, the fund resembles a passive fund.

Sectoral funds should be about active investment strategies and for that reason, the expense ratios are also higher. Thus, sectoral funds score low in terms of flexibility.

To illustrate the above point, let us take a simple example of a hypothetical “banking fund”, which currently holds SBI, ICICI Bank and HDFC Bank shares. The market expects the RBI to increase Repo rates, which is perceived as a negative development for the banking industry.

What would the fund manager of this Banking fund do? Even if the market correctly anticipates a rise in interest rates, would the fund manager sell all the 3 banking stocks?

What would he or she do with the amount realized? Would the money be invested in other “Banking” stocks? Will such other Banking stocks not be impacted by the rise in interest rates? More critically, what if the anticipated rise in interest rates does not take place?

3. The investor has to make hard decisions (which sector, when)

Even if we assume that the fund manager will find a way to manage the above situation, the decision to invest in a particular fund has to be made by us. Do we have the competence to be able to understand how different sectors will perform over the next few years? Most of the times, our decision to invest in a sectoral fund is on account of friendly advise received by our broker or financial advisor. Again, most of the times, they are selling to you the flavor of the season. Most advisors and brokers do not have the necessary knowledge to analyze and forecast industry performance.

Contrast this with a diversified equity fund. The diversified fund would also have exposure to the favorite sectors such as Pharma, IT, Infrastructure and Banking. However, when a fund manager anticipates that a particular sector, say Pharma, is unlikely to perform over the next few years, he or she would have the flexibility to move out of Pharma and reinvest in other promising sectors.

4. Higher Expense Ratio

Sectoral funds have typically higher total expense ratios. This is understandable as the returns from these funds are likely to be much higher. In other words, you end up paying higher asset management fees to the fund manager. Brokerage on these funds is also higher. While this should not matter as an investor looks for net return after TER is paid for, we must understand that higher TERs eat into our profit (Also read: ‘Why You Should Switch to Direct Mutual Funds’). Also, this needs to be paid even if the fund incurs a loss!

Conclusion:

Sectoral funds provide an opportunity for investors to invest in shares of a particular sector and have provided high higher returns. However, lack of flexibility, the concentration of investments in a few companies of a particular sector and higher TERs suffered by fund managers make sectoral funds an unattractive investment option.

Happy Investing!

Jama Wealth