Pratik Patel was delighted when he checked his mutual fund statement to realize that his holdings in an equity growth fund had earned an annualized return of 17% over the last 3 years. However, he also felt disappointed when he realized that the banking fund in which his colleague had invested had returned 27% annualized over 3 years. Pratik felt that he would he would have been better off being in the banking fund and is now seriously considering switching from his diversified equity fund to a banking fund.
The dilemma that Pratik faces is the classic dilemma that mutual fund investors face; whether to invest in diversified equity funds or in sectoral funds. Here are 6 pointers for you to make a fair decision..

You cannot just look at one dimension of sectoral funds

The dilemma for Pratik is arising because he is just looking at one dimension of sectoral funds. Banks have been among the better performers in the last 3 years. What would have happened if his friend had been exposed to a pharma fund or a technology fund? It is very likely that the friend would have clearly under performed Pratik. The out performance of banking funds is more because of timing and an exceptional performance cannot be taken as a rule. Profits made 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.

You are into mutual funds to achieve diversification of risk

Sectoral funds are actually against the basic grain of investing in mutual funds. Why do we invest in mutual funds? Apart from expert fund management skills and peace of mind, mutual funds also give us the benefit of diversification. That is something we find it difficult to achieve on our own as our resources are limited. By opting for a sectoral fund, you are compromising on diversification as the entire fate of your portfolio holdings are determined by the vagaries of that particular sector.

Sectoral benchmarks are not as reliable as broad-based benchmarks

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. Unlike the Nifty and probably the Bank Nifty, other sectoral indices are not heavily traded. Hence these benchmarks may not be too reliable. Also these indices are influenced by sector-specific factors and sectoral disruptions. When the telecom hardware industry is being disrupted by the likes of Apple and Samsung, historic valuations hardly make any sense.

You are exposing yourself to the dynamics of 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? It should not happen that the under performance of 1 or 2 sectors globally put paid to your retirement plans and your child’s education. That would be atrociously myopic on your part. From a portfolio point of view, you need to reduce your risk and try to maximize your returns for a given level of risk. Sectoral funds are too much of a risk to bear. For example the IT sector funds in India are largely at the mercy of Trump’s visa policies while the pharma sector is at the mercy of the FDA. Your portfolio does not have to be at anybody’s mercy.

What fits better into your long term plan?

I am sure that the answer is pretty clear by now. You do not want your financial plan to be vulnerable to a set of factors that you have no control over. That just does not make sense. A diversified plan may give lower returns but at least that will be more stable. At any point of time there are going to be some sectors that will outperform the index and that sectoral fund will outperform the diversified equity fund. But, the problem is in identifying these sectors. That is a hard prediction to make and definitely not worth the while.

Take a small exposure for the sake of alpha..

So, do we abandon the idea of a sector fund altogether. You can sit down with your financial advisor and consciously decide to take an exposure of 10-15% of your equity portfolio in sectoral funds. The key is to maintain this discipline. That is a good way of gaining some alpha through concentration risk without majorly impacting your overall portfolio performance. Even in a worst case scenario, the balance 85% of your equity portfolio is still in diversified funds and you can fall back on that.
Remember, when we are talking about financial plans and long term goals, diversified equity funds make a better case than sectoral funds. You can look at taking a small exposure in sectoral funds for the sake of alpha, but that is the maximum it should be!