What Are Sector Mutual Funds & Should You Invest In Them?
Sector mutual funds have been around for several years, but many have launched in the last few years as the Indian economy has grown and become more diverse. This guide hopes to cut through the jargon and confusion in the press around sector mutual funds. By the end, you will have a clear understanding of whether or not to add sector mutual funds to your investments, and how to go about it.
January 18, 2021
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Sector mutual funds are mutual funds that invest in companies that all belong to a particular sector. For instance, consumer goods is a sector. Healthcare is a sector. Energy is a sector. Banking is a sector.
While they stand to benefit from the growth in that particular sector, they also stand to lose if and when that sector performs poorly.
If you have a strong opinion about the future prospects of a particular industry sector, a sector mutual fund may be a good way to participate in that growth.
However, there are a few important factors to consider before picking a specific fund to invest in. We explore these in the article.
Important: This blog is meant to educate readers and the information furnished here is not to be construed as investment advice from Cube Wealth.
What Are Sector Mutual Funds?
Let's get it right out of the way: sector mutual funds are mutual funds that invest in companies that all belong to a particular sector like energy, banking, infrastructure, and more.
So a banking sector fund would invest in a set of publicly traded companies that are all in banking and closely related areas. An energy mutual fund would invest in companies that are involved in different aspects of energy: mining, energy generation, transmission and distribution.
You may also see sector mutual funds being termed sectoral mutual funds.
Sector mutual funds differ in more than just the sector that they invest in.
They may have widely differing sizes - that is, the amount of money that they manage (AUM).
They may hold companies that differ widely in size - a sector may include large and small companies. Therefore, sector mutual funds are often hard to classify as large cap funds or mid cap funds or small cap funds. They may hold stocks that are all three.
They may decide to take widely different risks from each other. After all, a 'hot', high-growth sector will have faster growing companies than a more established, slower growing sector, and therefore may hold companies whose stocks are more volatile and therefore higher-risk than the average.
They may have widely different investment objectives. Related to what we said above, a sector fund investing in a fast-growing sector may decide to pursue growth as an objective. A sector fund investing in a more traditional industry sector may decide to pursue dividend yield as an objective.
Sector mutual funds are different from thematic mutual funds, which is another term you might see:
Thematic funds invest in themes, which may span multiple sectors. For instance, there may be a mutual fund that invests in the theme of renewable energy.
Now that may span multiple sectors, including energy itself, but also maybe manufacturing, heavy industries, finance and others, because they may have companies that are related to renewable energy.
A sector mutual fund, on the other hand, will have a more concentrated focus on depth in a single sector and invest in what the fund manager thinks are the best companies in that one sector.
Sector funds are generally preferred by seasoned investors who have an in-depth understanding of macro trends. A seasoned investor would invest in a sector fund if they have conviction about the prospects of a particular industry sector.
If the investor thinks Indian IT services are going to do well in the next several years, they may consider investing in an IT services-focused sector mutual fund.
This is mainly because a sector fund will capture the rise of IT service companies better than, for example, an index fund that invests in the overall Indian market.
By investing in a sector mutual fund instead of individual stocks, you can act on your conviction without having to spend the time and energy researching and identifying the right entities in that sector.
A fund manager will do ongoing research, so they know not just what stocks to buy in that sector, but also which ones to sell and when. Consult a wealth coach before investing in any mutual fund.
Factors To Consider Before Investing In Sector Mutual Funds
Fundamentally, you should consider your asset allocation before investing in sector mutual funds. Asset allocation is how your investments are distributed across different assets, different risk levels and different lock-ins.
The main question you will discuss is whether a sector mutual fund is right for your particular portfolio. That is determined by the sort of risk you are capable of bearing in exchange for the returns you expect, and whether that sector mutual fund is the right way to achieve those returns at that level of risk.
As we said right at the beginning, different sector mutual funds choose to take on different risks. You will need to pick between them.
Even in a single sector, you may have two different sector mutual funds with different investment objectives and therefore with different risks (and returns). Which one of them is right for you?
Finally, is the fund manager the right one to run such a fund? What is their expertise in that sector, or their ability to access such expertise? Are they spread too thin managing too many funds?
A second but equally important question is whether you already own stocks in the same companies through your other investments:
You may have other large-cap or mid-cap or small-cap funds. You may own index funds. Any of these funds may invest in the same companies that your desired sector mutual fund or sector mutual funds may invest in.
If you invest in both these other funds and the sector mutual fund, you may invest more than is necessary for a specific company and increase your risk more than you had bargained for.
The third question about sector mutual funds is one of time. Sector mutual funds follow industry business cycles, just like the companies that they invest in do.
For instance, the construction sector is known to follow business cycles that last many years. Therefore, to gain the maximal benefit of such a cycle, you should know when to invest, when to exit, and also how long you are prepared to keep that money invested.
If you were to invest in a construction sector mutual fund at the end of a cycle but were not prepared to stay invested until the upward trend of the next cycle kicks in, then it would be a poor investment.
As with most things related to investments, a conversation about these factors is best had with a wealth coach.
Watch this video to know why you should not pick mutual funds on your own
Who Should Invest In Sector Mutual Funds?
The key for any investor, including yourself, is to own a diversified set of high-quality stocks as part of their equity portfolio, either directly or through mutual funds. If they are a good fit in terms of asset allocation, then sector mutual funds can be part of many investors' portfolio.
A sector mutual fund, by its very nature, carries sector risk. Which means that if the sector as a whole is affected negatively by certain factors, then the entire sector mutual will suffer, because it is not diversified across sectors in the way that index funds or large/small/mid cap funds are.
This means that while you may have faith in the sector today, you should be sufficiently vigilant to watch out for signs that a sector as a whole may be hit. You should also be aware that not all such events are predictable.
For instance, the ongoing pandemic has hit the travel sector particularly hard. A sector mutual fund that focused on Travel and Tourism, for example, would suffer accordingly. Most investors would have found it hard to anticipate such an event.
In other words, if you choose to invest in a sector mutual fund, be prepared to monitor the sector for not just opportunities, but also risks. If you’re investing in equity funds using Cube Wealth, you can get a detailed risk analysis and fund recommendations based on your goals.
Watch this video to learn why you need to be aware of your risk profile
Sector mutual funds are an attractive combination of the inherent diversification of mutual funds, and the sharp focus on a specific opportunity.
If you have a strong opinion on the prospects of an industry sector, a sector mutual fund is a great way of potentially participating in that growth without putting in the resources to identify individual stocks.
Sector mutual funds may be right for a wide range of investors, but you should consider a number of factors before investing in them. Among them:
Are they right for your risk profile
Do you already have exposure to some of the companies in that sector through your other investments
Are your investments in sync with the sector's business cycle
Have you have picked the right fund within the set of mutual funds for that sector
Bear in mind that sector funds demand comprehensive research and above-average risk tolerance. Other mutual funds like debt funds or international funds can be a suitable alternative.
If you’re investing using an app like Cube Wealth, you can gain access to curated funds handpicked by our expert wealth advisor, Wealth First. Currently, Wealth First curates funds in these categories:
At Cube Wealth, customers have a portfolio-level conversation with a Wealth Coach to determine what investments, including sector mutual funds, are right for them. Hundreds of families have already done so - get started by downloading the Cube Wealth app.
Not much of a reader? Watch Rahul’s talk on 5 rules to build a positive investing habit
Rahul Gaitonde is the Chief Operating Officer at Cube Wealth. An MBA from the Indian Institute of Management, Kozhikode, Rahul has been building teams from near-scratch, developing, releasing, and operating new products for over ~10 years. He is also one of the first to test out new assets with his own personal money before they are added to Cube’s platform.
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