Sectoral funds refer to equity funds typically invested in a particular sector or industry, such as technology, health care, energy, or financial services.
These funds focus at least 80% of their assets in stocks of companies operating within a given sector with the aim of exploiting its growth potential. Although sectoral funds can bring high returns when the sector performs well, they are also associated with greater risks due to the lack of diversification. Because their performance is closely indicated by the trends in the market of the sector, it is important that investors evaluate market cycles and economic situations before committing money to such funds.
These funds are suitable for investors who are willing to undertake more risks on the condition of possibly earning a higher reward in a volatile market. This article discusses what is sectoral mutual funds, how they operate and the advantages of having such funds.
What are Sectoral Mutual Funds?
Sectoral mutual funds are forms of equity funds that invest in businesses of an industry or sector. These investments are focused on companies belonging to a particular industry and allow investors to be selectively exposed to a particular segment of the economy. This is a specialised approach that allows investors to exploit the growth potential of industries that may grow in the medium-long term.
As an example, the technology industry may flourish due to innovativeness, whereas the banking industry might be successful in an economy that is performing well. By investing in sectoral mutual funds, you are able to intelligently invest in sectors that are likely to perform well hence earning the maximum returns.
Sectoral funds are particularly effective with investors who are well-informed on a particular industry or those who are willing to take some calculated risks.
How Do Sectoral Mutual Funds Work?
The Sectoral Mutual Fund operates by investing in a single sector. Here’s how it operates:
Raising Money through Investors
A sectoral fund just like any other mutual fund that gathers the funds from multiple investors. This money is meant to be invested in a certain industry.
Investing in a Specific Sector
Once their money is collected, the fund manager invests in companies within that industry.
For example:
– Banks, NBFCs, and insurance companies will be selected through a banking sector fund.
– An IT industry fund will select IT service providers, software companies, and online companies.
– Pharma sector fund will invest in healthcare and pharmaceutical firms.
Active Management of the Fund
The manager tracks trends, company earnings, government regulations, and world affairs that influence the industry. Based on this information, the manager will make decisions regarding what companies to purchase, the amount of investment and when to shift the portfolio.
Sector Performance-based Returns
Since all the funds are anchored in a single sector, the success of the fund will be limited to the performance of that sector. When the industry performs well, the fund may provide above-average returns. In case the sector performs poorly, the fund might fail to beat a more diversified fund.
Higher Risk, Higher Reward
When the selected sector performs well, sector funds can yield large returns. However, they are also riskier since the entire money is in a single field. These investments would be most suitable for those investors who can bear the extra risk and are attentive to the market trends.
Features of Sectoral Mutual Funds
The key characteristics of sectoral funds are:
Higher fees: Sector funds tend to have higher fees than diversified mutual funds since they need specialised reseach and management.
Greater risk exposure: These funds are concentrated in one industry, and thus they are more susceptible to market developments in that industry, which contributes to the risk of these funds as compared to diversified funds.
Potential to yield high returns: Sectoral funds can also yield high returns in case a particular sector is doing very well and therefore may attract investors who will have higher risk-taking capacity.
Performance variation: The returns of a given sector fund can fluctuate widely depending on the economy, industry trends and market cycles.
Absence of diversification: Sector funds usually concentrate on a single sector unlike mutual funds which spread out all their investments and thus lack diversification and expose them to a higher risk.
Who Should Invest In Sectoral Mutual Funds?
The following are the kinds of investors who may be interested in considering investing in sectoral mutual funds:
Active and Informed Investors
Sectoral funds do not suit beginners or people who lack experience. Investment in such funds requires perfect timing of entry and exit which can be challenging for inexperienced investors. Active investors who follow the latest news and trends in the market can calculate which sectors are doing well in the medium and long term. The funds are suited to long-time investors who have a good grasp of the sectors and knowledge acquired through thorough research.
Investors with Good Risk Appetite- Sectoral funds are high-risk investments because they are sectoral-specific funds that are not diversified. Thus, these funds should be considered only by risk-taking investors.
Investors Interested in Tactical Allocation- The financial status of some sectors are cyclical, and thus, investors who are not afraid of risking their money on companies at the lowest stage of their cycle can utilise sectoral funds to earn profits. You can invest in a sector when it is at the low point of the cycle and stay with your investment until it reaches its peak performance, then sell the funds to realize your profits.
What Are The Types of Sectoral Mutual Funds
Real Estate Funds- These allow investors with a small capital to invest in the real estate market.
Utility Funds- These are investments in good companies of the utility industry and are usually intended to give regular dividends.
Natural Resources Funds- Natural funds are dedicated to investing in oil and natural gas, energy, forestry as well as timber-related businesses.
Technology Funds- Technology funds provide investors with an opportunity to invest in technology.
Financial Funds – This type of fund primarily invests in companies within the financial sector, such as banks, insurance companies, and accounting firms.
Communication Funds – These funds focus on investment in the telecommunications sector and they have the potential to incorporate internet-based businesses too.
Healthcare Funds – These encompass companies and medical institutions like pharmaceutical firms and laboratory chains.
Precious metal Funds- These offer investors an exposure to different precious metals, such as gold, platinum, silver, copper and palladium.
Advantages of Sector Mutual Funds
Targeted Growth Opportunities: You can capture growth in such industries as technology, healthcare, or renewable energy.
Greater Return Potential: Concentrated investments enable funds to perform better when there is a booming sector.
Portfolio Diversification by Theme: Adding sector funds can provide a balance in case your core portfolio is excessively broad.
Professional Fund Management: Although they are focused, the investments are managed by experts to achieve maximum growth.
Risks of Sector Mutual Funds
The risks of sectoral mutual funds include the following.
High Volatility: Since the fund is concentrated in only one sector, its performance might be relatively more volatile compared to the performance of diversified funds.
Relying on Government Policies: Regulatory adjustments in areas like energy or infrastructure can have a large impact on returns.
Market Timing Required: When you invest at the wrong time, you may suffer losses hence timing is all that matters.
The Concentration Risk: Unlike mutual funds, which are diversified, the sector funds do not diversify risks to other industries.
Tips for Choosing the To Sectoral Mutual Funds
To choose the top sectoral mutual funds, investors need to consider the following points:
Assess Sector Potential: Invest in those sectors that have the likelihood of growing in the next 5 to 10 years.
Study Past Performance: No past returns guarantee future performance but past returns show the consistency of the fund.
Examine the experience of the Fund Manager: A competent fund manager could make a big difference in his or her ability to cope with the market fluctuations.
Align with Your Goals: Choose funds that fit your risk and investment horizon.
Limit Overexposure: Restrict sector funds to 10 to 15 per cent of your overall portfolio.
What are the Returns on Mutual Funds in the Sector Category?
A common question that many investors have is: How do the returns on mutual funds, like sector funds, compare to diversified funds?
The response is: It greatly depends on market conditions.
High Returns in Positive Cycles: In strong market phases, sector funds can yield returns of 15 to 25 per cent annually or even more. For example, IT and pharmaceutical funds have shown remarkable returns in recent years when demand was high.
High Risk in Downturns: Conversely, if the sector does poorly, returns can drop significantly. For instance, energy and banking sector funds encountered difficulties during economic downturns.
Therefore, while sector funds can excel during certain times, they shouldn’t make up your whole portfolio. A diversified strategy is more secure, with sector funds being just a portion of your investment plan.
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