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Diversified funds versus sector funds - How to make the choice

23 Nov 2023

Before we get into this comparison of sector funds vs diversified funds, let us understand the basic difference between diversified and sector mutual funds. While diversified funds are large cap funds which are spread across sectors and themes, the sector funds are more focused on a particular sector or industry group. So an IT Fund or banking fund or FMCG fund or even a Pharma fund would qualified as a sector fund. There are some basic questions you need to think up here. Firstly, you invest in mutual funds for the benefit of diversification, which you cannot get in direct equities. Buying sector funds makes your risk concentrated and goes against the basic grain of diversification. So the question is, “Should I invest in diversified or sector mutual funds and what should drive the choice?”

Let us look at 5 key factors to be considered to make this choice.

  • When you look at sector funds, look at long term cycles and risks

You cannot just look at one dimension of sector funds. A steel fund may do well during the upside of the steel cycle, but may grossly underperform after that. Similarly, a banking fund may do well when rates are falling but may underperform if rates start rising. Profits that are made in a sector fund by a stroke of chance cannot form the basis of your investment strategy. If you look at all the dimensions of a sectoral fund, then the answer will be much clearer. The rule here is to prefer diversified equity funds as your wealth creation machine and rely on sector funds only for short term alpha.

  • How do I diversify my risk with sector funds?

The answer is that you cannot diversify your risk with sector funds. To that extent, they go against the basic grain of investing in mutual funds. Why do we invest in mutual funds? Apart from expert fund management and peace of mind, mutual funds also give us the benefit of diversification. That means your spread your risk across themes and sectoral cycles. Since you do not have the ability and the capital to do that yourself, you are relying on a fund manager. By opting for a sectoral fund, you are compromising on diversification as the entire fate of your portfolio hinges on the vagaries of one particular sector.

  • How do you benchmark the performance of sector funds?

That is a big challenge. You can benchmark your diversified funds against Sensex and Nifty. But sector funds become a lot more complicated since we do not have representative indices. For example, the FMCG index has a 42% exposure to ITC and if you avoid ITC you are more likely to outperform the index. When you get into mutual funds, one of the essential benchmarks you can use is to see whether the overall index is undervalued or overvalued with respect to its trading history. For the Nifty, buying around the 15 P/E and selling around the 26 P/E has worked well over the last 25 years. But it is hard to get such reliable benchmarks for the sectoral indices.

  • You tie your portfolio performance  to the vagari9es of just one sector

That is the question you need to ask yourself! Do you want your long term goals to be tied to the fortunes of one sector? Frankly, that is not a very good idea. It should not happen that the underperformance of 1 or 2 sectors globally put paid to your retirement plans and your child’s education. So, obviously, you can bet your bottom dollar or rely on sector funds for you long term goals. AT best it can be a short term solution to a short term trend. For example the IT sector funds in India are largely at the mercy of US visa policies, which have been extremely unstable under Donald Trump. The pharma sector is at the mercy of the US Food and Drugs Authority (FDA). That is the downside risk of sectoral portfolios.

  • The answer lies in treating sector funds as alpha hunters

The answer may not be to abandon the idea of a sector funds altogether. Sit down with your financial advisor and take an exposure of 10-15% of your equity portfolio in sectoral funds. The key is to maintain this discipline and ensure that you have a clear exit plan too. That way, you make some alpha through concentration risk without impacting your overall portfolio performance. Even in a worst case scenario, the balance 85% of your equity portfolio is in diversified funds you can fall back on.

When we talk about financial planning and long term goals, diversified equity funds are a better option than sectoral funds. However, you can look at taking a small exposure in sectoral funds for the sake of alpha, nothing more than that!

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