Back in the peak of the technology boom in 1999, a plethora of Indian mutual fund houses had brought out new issues of sectoral funds. Not surprisingly, most of the themes for these sector funds revolved around software, telecom and media. They were the hot sectors during the technology boom and obviously it must have been pretty easy to sell these funds to hungry investors. The whole concept of sector funds has a certain inherent dichotomy built into it. Here is why..

One of the main justifications for buying mutual funds is the benefit of diversification. That is why when we talk of mutual funds, we normally talk of diversified mutual funds. The idea is to spread your risk across stocks so that you are not exposed to concentration risk. But buying a sector fund with focus on a single sectoral story defeats this purpose. So the question is whether investing in sector mutual funds is a good idea in the first place? Should I invest in sector funds or avoid it altogether. Above all, are there are special circumstances when to buy sector funds?

Ideally try to invest when the sectoral up-cycle is starting
You have identified that the massive infrastructure spending by the government and the encouragement to agriculture is going to be positive for companies focused on rural demand. So a sector fund focusing on tractors, fertilizers and agrochemicals would be a great idea. The idea is to buy when the cycle starts and have the patience to wait. If you buy closer to the peak (like tech funds in 1999 and commodity funds in 2007), then you are unlikely to get the full benefit of sector funds. The more you spend time in the up cycle with the sectoral fund, the more likely you are to make big profits. Avoid the herd mentality.

How much of sector funds; that is more important than when to invest
A very important decision when you buy sector funds is now whether but how much. Keep a sense of perspective. If you are expecting a major up-cycle in banking and you want to risk 10-15% of your corpus in banking sector funds, then it is perfectly understandable. But allocating 50% of your corpus to banking funds is not a good idea at all. You are over-exposing your portfolio to banking a little too much and defeating the basic purpose for which you invested in mutual funds in the first place. Have a sense of perspective and do not let sector funds cross 10-15% of your overall mutual funds allocation even if you are lucky enough to catch the bottom of the cycle.

Avoid sector funds when there is a deluge of NFOs
What was common between 2007 and 1999? In both these years, there was a deluge of new fund offerings (NFOs). No prizes for guessing but all NFOs in 1999 were centred on technology stocks and all NFOs in 2007 were centred on commodities. Normally, the deluge of NFOs happens when the sector is at a peak and selling the story to investors is a virtual cakewalk. That is the time to avoid sector funds. The moral of the story is to avoid sector funds if you see a deluge of NFOs. It only indicates that selling the story has become just too easy and that means it may not be really sustainable for much longer. That is the time to be cautious on sector funds.

Don’t chance your luck for too long on sectoral funds
Any sectoral fund has a cyclical risk. There is a hardly a sector that has not gone through cycles, for different reasons. Technology and Commodities are the better known down cycles post 1999 and 2010 respectively. But post 2008 infrastructure had a huge down cycle; post 2011 capital goods had a huge down-cycle. In fact, post 2005 even FMCG had a huge down-cycle when competition thinned margins to almost unsustainable levels. The idea in sector funds is to not wait till the end of the cycle but take profits off the table once your target is met and revert to the safety of diversified mutual funds. As long as you can maintain that discipline you are absolutely entitled to seek opportunities in sector funds.

Treat the sectoral fund as a less risky version of a call option
What do you do when you buy a call option? You are actually prepared to lose the premium that you pay for the option in the hope that under certain circumstances you may end up making huge profits. You need to approach sector funds from a similar perspective. Envisage a worst case scenario and keep that loss as your option premium risk. If you buy a sector fund at an NAV of Rs.10 then keep 30% downside risk as your call premium. If it goes below that then just take the loss and exit your sector funds position. You are better off taking the hit and reverting to the safety of diversified equity funds.

There is nothing wrong in sector funds and at times they can be great idea if you manage to accumulate them at salivating prices. For example, technology sector funds were available in 2001 and 2002 and hugely discounted NAVs in the range of Rs.2-3. Had you bought these sector funds at those prices, you would be sitting on virtual multi-baggers. The crux is to keep your sense of perspective!