Sector funds - Do’s and Don’ts

For the uninitiated, a sector fund invests its pool of resources in securities belonging to a particular sector. An FMCG fund, therefore, will tank up on the Levers and the P&Gs of the world. And that, in a manner of speaking, means that sector fund’s investment universe is well-defined, limited and narrow.

The often-untold story is that a sector fund will run its course at break-neck speed when the sector concerned is doing well. Rewind to the phase early this decade when information technology companies saw their market-cap soar to Himalayan heights. Naturally, the NAVs of sector funds that invested in information technology stocks went through the roof. But the NAVs of infotech funds plummeted when the internet bubble burst.

A financial advisor, especially one who is aware of historical trends, would be confronted with, and troubled by, the supreme question: Should I recommend sector-specific funds to clients?

The answer, dear reader, is not a straight one. Such a recommendation would be a factor of several issues. And, before we delve deeper into the relative merits and de-merits of sectoral products, let’s quickly check out the more important of these issues. Here goes:

1. Will the client’s risk-profile permit exposure to sector funds? If it does, to what extent should the exposure be?
2. Does the client know enough about the risks he is taking when he invests in, say, a power sector fund? He may need explanation and clarity.
    
3. Even within seemingly narrow sectors, can the funds in question potentially diversify into related areas? For instance, can the same power-sector fund allocate to power equipment manufacturers (besides power generating and distributing companies).

The big issues…

Will the client’s risk-profile permit exposure to sectoral funds? Is he aware of the risks? Does he have enough appetite for such risks?

Mind you, restricting your allocation (however small) to just one sector does result in big risk. Over-exposure, indeed, is potentially suicidal. Just imagine what will happen when, say, 60 per cent of an investor’s portfolio is directed towards a single sector… at a time when its fortunes have been crushed by economic upheavals?

So, the point we wish to reiterate is that sectoral products may well be extremely, extremely dangerous when they are wrongly recommended.

Sector funds may turn into an investor’s friend as well. A simple case in point: the banking sector in India at the moment and the funds that are generally known as `banking sector funds’. Just look at the raw statistics - a huge upsurge in NAVs of these products in the last 12 months or so.

Think of an investor who had taken a decent sort of exposure to a well-performing banking sector fund. He has, by now, plenty to boast about. That becomes possible because the stock markets have favoured banking stocks in the recent past. So, the lesson learnt here is that sector funds can do wonders if the entry and exit timing turns out well.

Sector funds may turn into an

Investor’s friend as well…but are they purely a timing-game? Don’t they need special attention, education and information-dissemination?

Are sector funds purely a timing-game? It looks like they are – given the nature of sector runs that we have seen in the past (actually, ever since the first product in the genre was launched).

An advisor who studies the sectoral products must consider the following points:

• It may not be prudent to remain in a sector fund for far too long – recommend an exit when you see the first signs of a reversal – these signs may be the early stages of a significant downtrend in that sector.
• A client may be urged to book profits at regular intervals even when a sector fund of his choice is scaling new heights. This is purely a risk-containment measure.
• A distributor/advisor will have to possess a clear view of the sector in question. He must use all resources at his disposal in order to gain insights – after all, an extra cautionary measure goes well with the added risk a client is taking when he invests in a sector-specific fund.

An advisor may follow a specific strategy on educating clients when it comes to recommending sector funds. The former must explicitly state that these funds can potentially gain higher than the broad market but at the same time carry extra risks. In this context, the issues to remember are:

1. When the economy generally grows, some segments grow at a quicker pace, more than the average performer.
2. Investment in sector funds must be backed by added attention and caution.
3. A sector-specific approach is often the hallmark of aggressive investment styles. Risks are higher; potential gains too are more.
4. Allocation - even a modest 10 per cent of investible funds - should be determined by the investor’s risk-appetite and by no other standard or benchmark.