Supercharge Your Portfolio with Sectoral Funds

Sectoral mutual funds are equity schemes that focus on specific sectors of the economy, such as automotive, BFSI, energy or infrastructure. They aim to invest in sectors anticipated to perform well while avoiding those expected to underperform. Rakesh Deshmukh takes you through the selection of the right sectors and explains why including sectoral funds in your portfolio is beneficial [EasyDNNnews:PaidContentStart]

Surely you have heard someone inquire about which sector is booming currently and which one is expected to be the top performer in the future. Having good knowledge of sectors with recent developments or those where the government is focusing on development can significantly impact the companies within those sectors. This is crucial for investors to stay informed, not only to invest in the market but also to profit from market movements. 

Sector rotation is an investment strategy where investors shift their investments from one sector of the economy to another based on economic cycles and market conditions. The idea is to invest in sectors that are expected to perform well in the current phase of the economic cycle while moving away from those that may underperform. The goal of sector rotation is to enhance returns by capitalising on the performance of different sectors at various stages of the economic cycle. 

For instance, after the corona virus pandemic, the IT sector experienced a strong rally but later remained subdued for an extended period, which is typical of market behaviour. From April 2020 to December 2021, the Nifty’s IT sector index, Nifty IT, rallied approximately 240 per cent, while the FMCG index registered a growth of around 70 per cent during the same period. Since reaching its high point, the Nifty IT Index has generated only about a 3 per cent return, while the FMCG sector has grown by around 50 per cent during the same period. 

When one sector is thriving, others may not perform as well. However, as the leading sector stabilises and consolidates, other sectors often start to rally and demonstrate their performance. Generally, it has been observed that at least one sector performs well in the market, contributing to market growth, unless there is a significant downturn affecting the entire market. For instance, defensive sectors like healthcare and utilities tend to outperform during economic downturns, while cyclical sectors like consumer discretionary and industrials thrive during periods of economic expansion. 

Before planning sectoral funds, it is crucial to grasp the concept of sector or sectoral funds and their capacity to generate substantial returns. While diversifying your portfolio is a vital risk mitigation strategy, it can potentially hinder your returns. This is because, at any given time, specific sectors in the economy outperform, some perform adequately, and others may fall short in terms of performance. 

Sectors and Sectoral Funds
First, it’s essential to comprehend the concept of a sector before delving directly into sectoral funds. A sector comprises a group of companies that operate in the same line of business, indicating that they either offer the same or similar types of products and services. For example, Maruti Suzuki and Tata Motors fall within the automotive sector, while HDFC Bank and ICICI Bank are part of the banking and financial services sector. sectoral mutual funds are equity schemes that target specific sectors of the economy, such as automotive, BFSI, energy or infrastructure. 

Also called sectoral funds, these funds invest in stocks from companies within the selected sector, irrespective of their market capitalisation or type of security. They offer investors a chance to put their money into the leading stocks within that sector. As per the guidelines of the SEBI, a sectoral fund allocates a minimum of 80 per cent of its investments to equity and equity-related instruments in a particular sector. The remaining 20 per cent may encompass debt instruments, including bonds and government securities. 

What History Says

The table above illustrates the calendar year performance of various sectors. The data suggests that in 2014, the market was indeed in an uptrend, as the major sectoral indices closed the year in positive territory. However, when we examine the sectors more closely, we see that banking and automotive were the best-performing sectors. These sectors not only outperformed others but also created significant wealth for investors. Looking at 2015, the data suggests that market conditions were not as favourable compared to the previous year i.e. 2014, with all major indices closing the year in negative territory. The metal and realty sectors were the biggest losers in 2015. However, the top-performing sectors among all sectoral indices were those that fell less compared to others. 

The energy, IT and automotive sectors performed relatively well, managing to close the year with a fall of less than 10 per cent, despite their efforts to end on a positive note. Lastly, in 2023, stocks from the realty, CPSE and automotive sectors have outperformed others, rallying around 81 per cent, 74 per cent, and 48 per cent, respectively. In contrast, the banking and metal sectors have not impressed investors with their performance. From this data, we can clearly see that a positive market mood is essential for boosting the performance of various sectors. Different sectors contribute to overall market growth at different times, as evidenced by the performance of sectors like CPSE, automotive and realty during different years. 

What if you had added a Sectoral Fund to your Portfolio?
Suppose you had begun investing in mutual funds in 2023 and added a Large-Cap fund to your portfolio with an investment of ₹1 lakh on January 1, 2024. Also, let’s compare the returns of your portfolio with and without including a sectoral fund. What would be the returns in each scenario? 

Your sectoral fund would have generated over 110 per cent returns, as shown below. 

Look at the difference in the value of your portfolio. Adding a sectoral fund, such as an index fund (in this case) representing the automotive sector, could have significantly boosted your portfolio. With a single large-cap fund, your portfolio grew to ₹1.62 lakhs only. By adding the sectoral fund, your portfolio value would have increased by ₹1.11 lakhs more, reaching approximately ₹3.73 lakhs, resulting in an absolute return of around 87 per cent. 

Why Should Sectoral Funds be a part of your Portfolio? 

Focused Exposure - Sectoral funds provide targeted exposure to specific sectors of the economy, allowing you to capitalise on growth opportunities in those areas. If you believe a particular sector, such as technology or defence, will perform well, investing in sectoral funds can give you focused exposure. Due to the geopolitical tensions caused by the war, India is focusing on defence spending, resulting in defence stocks rallying impressively over the past year. 

Potential for Higher Returns - If a particular sector experiences significant growth, sectoral funds can offer higher returns compared to more broadly diversified funds. This can be especially beneficial during periods when certain sectors outperform the general market. Combining with your core portfolio, sectoral fund as a satellite portfolio helps you to elevate your overall portfolio returns. 

Strategic Allocation - Sectoral funds allow you to adjust your portfolio based on market conditions and economic trends. For example, during a period of economic expansion, you might increase your allocation to booming or trendy sectors, while during downturns you might shift to defensive sectors such as FMCG. As discussed above, during the pandemic, the IT sector performed well and delivered higher returns compared to other sectors. In the past year, the PSU, realty and infrastructure sectors have performed well among others. Identifying the right sector helps you strategically allocate your capital in sectoral funds. 

Diversification within Sectors - Not only is diversification among large-cap, Mid-Cap and Small-Cap funds important, but constructing a mutual fund portfolio with sectoral funds helps in diversification. Although sectoral funds concentrate on a specific sector, they typically include a range of companies within that sector. This diversification within the sector can help manage risk compared to investing in individual stocks. 

Factors to Consider Before Investing in Sectoral Funds 

Select the Right Sector and Sector Outlook - Before investing, carefully select the sector that aligns with your investment goals. Assess the growth potential and the overall outlook of the sector by researching industry trends, economic conditions and forecasts. This includes understanding advancements, investors’ behaviour shifts, and market demand. Ensure the sector has favorable long-term prospects and is likely to benefit from emerging opportunities. 

As has been seen, a large-cap fund in your portfolio might have delivered only 62 per cent absolute returns. In contrast, incorporating sectoral funds could have boosted your portfolio return to 87 per cent during the same period. Sectoral funds can offer substantial profits, but choosing the right sector is essential. For example, the media sector has underperformed this year, showing a negative return of around 12 per cent. This highlights the importance of selecting the right sector for your portfolio. 

Economic Cycle - Consider the current phase of the economic cycle when choosing a sector. Some sectors tend to perform better during periods of economic expansion due to increased consumer spending and innovation. Conversely, defensive sectors like utilities and healthcare may be more resilient during economic downturns or recessions, providing stability when the market is volatile. For example, the pharmaceutical sector performed well during the pandemic. 

Sector Volatility - Evaluate the historical volatility of the sector. Sectoral funds can be more volatile than diversified funds because they concentrate on a specific area of the economy. Understanding the sector’s risk profile, including past performance during market fluctuations and its sensitivity to economic changes, is crucial. This helps in assessing whether you can handle the potential ups and downs of investing in that sector. 

Investment Horizon - Align your investment in sectoral funds with your investment horizon. Sectoral funds may be more suitable for long-term investments due to sector-specific cycles and fluctuations. For example, if a sector is expected to experience growth over the next decade, investing with a long-term perspective can help you ride out short-term volatility and capitalise on long-term gains. 

Economic and Regulatory Risks - Understand the economic and regulatory risks associated with the sector. Changes in regulations, government policies, and economic conditions can have significant impacts on sector performance. For instance, policy changes in environmental regulations can affect the energy sector, while healthcare reforms can impact the pharmaceutical industry. Assess how these risks might influence the sector’s stability and growth prospects. 

Correlation with Your Core Investments - Evaluate how the sectoral fund fits into your overall portfolio. Ensure it complements your existing investments and contributes to a well-balanced portfolio. Consider how the sectoral fund’s performance correlates with your core investments to avoid overexposure to a single sector or asset class. Diversification across sectors and asset types can help mitigate risk and enhance overall portfolio stability 

Identifying Sector Rotation 

Government Actions - Recently, the Indian government announced the budget for the upcoming fiscal year, highlighting various investments across different sectors. This provides clues about where the government is focusing its efforts. For instance, if the government increases expenditure on the defence sector to enhance national security, it is likely that the defence sector may outperform in the near term due to increased spending and investment. Pay attention to government policies, regulations, and incentives that may impact sector performance, such as subsidies for renewable energy or changes in healthcare regulations. 

For instance, Finance Minister Nirmala Sitharaman recently introduced the Pradhan Mantri-Surya Ghar Muft Bijli Yojana (PM Free Electricity Scheme). This initiative aims to promote rooftop solar (RTS) installations in India by offering free electricity for up to 300 units per month to one crore households. This resulted in solar stocks going through a rally and even today solar stocks are on the radar of investors as they have the potential to yield substantial profits. 

Analysing Historical Performance - Analyse the historical performance of sectors during similar economic conditions. This can give insights into how sectors have reacted in the past and may react in the current environment. Compare the performance of different sectors to identify which ones are outperforming others. 

Economic Reports and News Trends - Monitor government and economic reports that can impact various sectors, such as infrastructure spending or regulatory changes. Staying updated with news related to specific sectors is also crucial. For instance, shifts in energy policies could significantly benefit the renewable energy sector. By keeping an eye on both economic indicators and sector-specific news, investors can better anticipate which sectors may experience growth or face challenges, allowing for more informed investment decisions. 

For instance, the government is concentrating on major infrastructure projects, having developed notable structures such as the Atal Setu Bridge, Atal Tunnel, Bogibeel Bridge and the Chenab Bridge—the world’s highest railway bridge located in Jammu and Kashmir. Recently, Indian Railways successfully conducted a trial run of an eight-coach MEMU train on this bridge, demonstrating the government’s commitment to large-scale infrastructure projects. Additionally, the trend in the infrastructure index supports this focus, indicating that those who invested early in the right sector have seen substantial wealth accumulation. 

Earnings Reports and Sector-Specific Metrics - Review earnings reports and guidance from leading companies within each sector to assess the overall health of the sector. Additionally, analyse metrics relevant to the specific sector. Combining insights from earnings reports with sector-specific metrics provides a comprehensive view of sector performance and potential investment opportunities. 

Money Flows and Analyst Reports -Monitor mutual fund and ETF flows to gauge where institutional and retail investors are allocating their money. Large inflows into a sector can signal growing interest and potential future performance. Additionally, read sector analysis and recommendations from financial analysts and investment research firms to gain insights into current trends and expert opinions. Combining these sources of information helps in understanding the market sentiment and making informed investment decisions. 

Conclusion
Sectoral funds can be a valuable addition to your mutual fund portfolio for several reasons. By focusing on specific sectors of the economy, these funds offer focused exposure and the potential for higher returns, particularly during periods when certain sectors outperform the broader market. Investing in sectoral funds, in conjunction with diversified mutual funds, can enhance portfolio returns and provide opportunities to benefit from sector-specific growth. 

The challenge for the investors is to fund the right sector(s) and stay informed about government policies, economic reports and sector-specific news. Along with monitoring fund flows and analyst reports, investors can make more informed decisions and potentially improve their investment decision on selecting the right sector(s) and eventually the outcomes. When allocating capital into sectoral funds, investors should consider dedicating no more than 10 per cent to 20 per cent of their overall capital to these funds. 

It is crucial that sectoral funds should not constitute the core portion of an investor’s portfolio, which is intended to be for a long term. Instead, sectoral funds should be part of a satellite portfolio, allowing for flexibility and adjustments based on market trends and evolving conditions. This approach helps balance the stability of core investments with the potential growth opportunities offered by sector-specific investments. 

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