Pharma Funds : Investment Potential

Investors often assume that investing in the pharmaceutical sector is a safe bet given that its products and services are always in demand. However, investing in pharmaceutical funds requires a constant study of the market and the sector. Moreover, as they are more focused on a single sector, they offer no diversification benefit. Hence, even though they offer potentially higher risk, their underlying return is also on the higher end. Therefore, before you head towards investing in them, understand your risk profile, investment objectives and time horizon [EasyDNNnews:PaidContentStart]

The Indian equity market, over the past few quarters, has witnessed substantial gains. This has resulted in heightened inflows into equity mutual funds. One important trend is sectoral or thematic mutual funds that are capturing investors’ attention, drawing in nearly ₹14,000 crore of inflows in the last five months. On a year-to-date (YTD) basis, sectoral or thematic funds had a cumulative net inflow of ₹22,871 crore. This surge signifies a growing interest among investors willing to take on higher risks for potential rewards. Recent data from the Association of Mutual Funds in India (AMFI) highlights a shift in these funds’ fortunes, as indicated in the table below:

 

After a withdrawal of ₹169 crore in May, sectoral or thematic funds have consistently seen inflows since June 2023. In the month of October, thematic funds got a huge inflow of ₹3,896 crore, the second highest among equity categories. These sectoral or thematic funds focus on specific sectors or themes and are for investors comfortable with higher risk. In this article, we would be speaking about one of the standout performers of 2020 that experienced a downturn from August 2021 to March 2023. Nonetheless, it started to rebound at the onset of the financial year 2024. Indeed, we are talking about pharmaceutical funds. 

The Nifty Pharma index surged from a low of 11,542.45 to a high of 16,279.10, resulting in impressive absolute returns of 41 per cent over a mere nine-month period. Concurrently, pharmaceutical funds delivered an average return of 38 per cent during this timeframe. Such a significant growth might instigate a fear of missing out (FOMO) among numerous investors. 

However, it is pivotal to grasp the fundamentals before considering investing in pharmaceutical funds. Understanding what these funds are, comprehending associated risks, exploring their tax treatment, understanding their suitability, evaluating key considerations before diving in, and examining their valuations and historical performance are crucial steps to make an informed investment decision. 

Understanding Pharmaceutical Funds

Pharmaceutical funds or pharmaceutical mutual funds are those mutual funds that predominantly invest in pharmaceutical and healthcare companies. Although the theme across the funds is similar, they might differ in their stockpicking philosophy. Currently, there are close to 14 pharmaceutical funds of which:

■ Ten are benchmarked against the S&P BSE Healthcare TRI
■ Two against Nifty Pharma TRI
■ Two against Nifty Healthcare TRI. 

Now you may ask if there is a difference between healthcare and pharmaceutical sectors. The healthcare sector is where you would find companies owning hospitals and laboratories, while the pharmaceutical sector includes companies that deal with medicines. However, if we closely monitor the constituents of healthcare and pharmaceutical indices, then there is barely any difference. 

As can be seen from the table above, 70 per cent of the top 10 holdings of the S&P BSE Healthcare TRI and Nifty Pharma TRI are common. Hence, it is safe to say that most of the healthcare funds are closely associated with pharmaceutical funds.
 

Risks Involved in Pharmaceutical Funds

On the front, you might think that pharmaceutical funds carry less risk being a defensive sector. However, they are as volatile as Mid-Cap funds. The volatility, as measured by standard deviation of the pharmaceutical funds is 10.2 per cent, while it is 10.8 per cent for mid-cap funds. Moreover, pharmaceutical funds are focused on a single sector i.e. pharmaceuticals or healthcare and they have a higher concentration risk. So, if the pharmaceutical sector faces a major setback, funds associated with this sector too would follow suit. 

"The pharmaceutical industry is poised to play a crucial role within this landscape of transformative growth. Fuelled by a commitment to transformative innovation and bolstered by government initiatives toward universal health coverage, the industry aspires to surpass the USD 450 billion mark by 2047. "

Suresh Subramanian, Partner, National Life Sciences Leader, EY India 

Moreover, as most of the pharmaceutical companies generate their revenues from the U.S., they are also prone to country risk. This means that any changes in the U.S. law would have an adverse impact on the pharmaceutical companies. Further, they also need clearance from the U.S. Food and Drug Authority (USFDA) that inspects the pharmaceutical companies’ manufacturing and research and development units. This has a significant impact on the performance of the pharmaceutical companies. 

Taxation of Pharmaceutical Funds

According to the Securities and Exchange Board of India’s (SEBI) circular on rationalisation of mutual fund schemes, pharmaceutical funds are categorised under equity mutual funds. Hence, the tax treatment of these funds is similar to equity funds. If you gain from selling the units of pharmaceutical funds within one year from the date of purchase, it would be classified as short-term capital gain (STCG). STCG is taxed at 15 per cent plus cess and surcharge irrespective of the individual’s Income Tax slab. 

If you gain from selling the units after one year from the date of purchase, it is deemed to be long-term capital gain (LTCG). LTCG of up to Rs1 lakh is tax-exempt. Any gain above ₹1 lakh is taxed at 10 per cent plus cess and surcharge irrespective of tax slabs. Moreover, if you have opted for its dividend plan, then like equity funds, it would be added to your overall income and would be taxed as per your tax slab. 

Pharmaceutical Funds’ Target Investors

Pharmaceutical funds predominantly invest in pharmaceutical and healthcare companies. Therefore, they carry concentration risk. So, when the pharmaceutical sector is doing well, its funds are expected to beat frontline indices such as Nifty 50 and S&P BSE Sensex. However, if they turn out of favour then they might show larger drawdown compared to the frontline indices. Therefore, they are high risk – high reward investments. Those who have the ability and willingness to take higher risks for potentially higher returns might want to consider investing in pharmaceutical funds. However, investing in them requires a thorough study of the market and the sector. 

Moreover, this is more of a tactical play rather than a strategic play, making it riskier to allocate funds to any of your financial goals. Hence, do not include pharmaceutical funds in your core portfolio. Rather, keep it in your satellite portfolio. The core portfolio provides stability and is intended for meeting long-term goals such as retirement or funding a child’s higher education. Satellite portfolios are tactical allocations in which one accepts greater risks in order to generate higher portfolio returns. Therefore, you need to ensure that you monitor the satellite portfolio on a continuous basis because any change in the trend or any sector moving out of favour is likely to impact your returns 

Points to Note
Before rushing to invest in pharmaceutical funds, here are a few things that you should consider: 

■ Risk Profile - Pharmaceutical funds are a high risk – high reward proposition. Hence, understanding your risk profile before investing in them is prudent. They are not suitable for investors with conservative risk profiles.
■ Investment Tenure - As pharmaceutical funds are concentrated towards a single sector, it is always prudent to invest in them for the long term. Your investment horizon should not be less than seven years. Investing in them for the long term would help in lowering the risk.
■ Check the Portfolio - Before investing in pharmaceutical funds, check the individual stocks they hold in the portfolio or at least look at their top holdings. This will give you a sense of what stocks would likely drive the performance of these funds.
■ Fund Manager - A fund manager is the captain of the fund and most of the stock selection decisions come under their purview. Therefore, understanding the performance history of the fund manager is equally important. This will help you have more conviction while investing in these funds. 

Sector Valuation
Analysing the valuations of the pharmaceutical sector would help us understand whether or not this sector is available at reasonable valuations. This will help in making better investment decisions. To understand the valuations, we would be looking at the price-to-earnings (PE) ratio of Nifty Pharma index. 

As can be seen in the graph above, the PE as on November 30, 2023 was at 32.7 times. This is below its historical median of 34.3 times. Even its price-to-book (PB) ratio is trading at 4.4 times – below its historical median of 5.3 times. This means that the sector is trading at reasonable valuations. 

Timing the Investment

In FY24, the pharmaceutical sector anticipates high single-digit domestic growth. Furthermore, growth in the U.S. market is expected to stay strong. This may be attributable to price normalisation in the core business as well as the ongoing ramp-up of gRevlimid and new product releases like gSpiriva and gPrezista. In the U.S., supply restrictions have prompted most company leaders to forecast a strong drop in price erosion, which is projected to continue into FY24. In India, however, growth has been driven mostly by price hikes and robust growth in chronic medicines, with all major businesses forecasting high single-digit growth in FY24. 

Margins are also expected to increase as raw material and freight costs normalise, price erosion in the U.S. subsides and a better mix comes into play. However, U.S. Food and Drug Administration (USFDA) inspections remain a concern, and price erosion in the U.S. is projected to accelerate as supplies return to normal. Therefore, investing in pharmaceutical funds can prove to be beneficial. Even though this sector has jumped quite a bit in the past nine months, the valuations still seem to be reasonable. Hence, there is a lot of performance potential in these funds. 
 

"The pharmaceutical industry is the art of making billions from milligrams."
- Gerhard Kocher, Economist 
 

Conclusion

Pharmaceutical funds are more suitable as a tactical investment rather than a strategic investment. Therefore, investing in them requires a constant study of the market and the sector. Moreover, as they are more focused on a single sector, they offer no diversification benefit. Hence, even though they offer potentially higher risk, their underlying return is also on the higher end. Therefore, before you head towards investing in them, understand your risk profile, investment objectives and time horizon.

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