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Should you buy sectoral funds?

Summary: The sharp focus and concentrated portfolios of sectoral funds have the potential to give high returns. But they also carry a higher risk.

It all started in 1999 at the height of the dotcom boom. Kothari Pioneer launched the country's first technology fund, starting a trend that soon became frenzied. The funds investing in companies with an 'e-' or a '.com' in their names posted 30% monthly returns. However, the period of plenty was short-lived; by 2000-1, the bubble had burst.

There are many lessons that have been learned from the dotcom collapse, including the fact that sector-specific or focused funds do very well if the sector was faring decently. The converse also holds true; the fund's value can be erased if the sector goes through a rough patch. For instance, globally, the dotcom crash wiped out $5 trillion in market value for technology companies from March 2000 to October 2002. But savvy investors, who exited before the crash, made a good profit. This, in a nutshell, is why focused funds are still popular.

Today, there are various sectoral funds that invest in sectors like banking, pharmaceuticals, fast moving consumer goods (FMCG), infrastructure, media & entertainment and natural resources. There are also funds that take a segmental exposure (mid-cap, small-cap, contrarian, etc), investing in companies that fall within a certain market segment.

NOT FOR FIRST-TIMERS: As we have already mentioned, these funds are for savvy investors. According to Srividhya Rajesh, fund manager at Sundaram BNP Paribas Mutual Fund, focused funds are meant for investors who are familiar with equities; first-timers are better off with diversified funds. This is because choosing a sector requires some knowledge about the factors influencing its business.

Take IT. It has been the top-performing sector for three consecutive months, delivering returns of 27% compared to the 5% rise in the index. Why the resurgence? A resurrection in the global economy, especially the US, resulted in increased IT spending. This, coupled with domestic tax breaks, has proved promising for the sector. To have been able to take advantage of this move, investors would have had to track the US economy and understand how it would have affected domestic IT, etc.

Vikas Agnihotri, CEO, Religare Macquarie Wealth Management, suggests that investors can have the best of both worlds by adopting a core and satellite approach to building an equity portfolio. This involves investing nearly 60% in well-diversified, less volatile funds (core funds), while 0-40% can be held in focused or thematic funds (satellite funds), with the maximum exposure to a single fund being restricted to 20%. "This is because focused funds take a concentrated exposure and, therefore, inherently carry a higher risk than the diversified funds, says Agnihotri. Consequently, there is a probability of being rewarded with higher returns, he adds.

WHY DIVERSIFIED FUNDS: If you don't think you have the expertise to track the broader markets, stick to diversified funds and leave it to the fund manager. A diversified fund can change sector weightages depending on the fund manager's research, says Jayesh Gandhi, executive director, Morgan Stanley Investment Management. He cites the example of the Morgan Stanley A.C.E. fund, which has 52% of its portfolio invested in infrastructure. Gandhi feels this theme will continue to do well considering that India is going to invest heavily in infrastructure for the next 5-7 years.

But since infrastructure has a high beta, the fund manager has cushioned the portfolio by adding consumer products and pharma stocks. Then there are funds like Reliance Banking that can take a 100% exposure to equities if the fund manager feels the market will do well, or shift the portfolio focus to 100% debt in case he feels the market is going to be bearish. One should understand the fund and its mandate before buying.

THE TECHNICALS: Focused funds typically hold a concentrated portfolio of 20-30 stocks to gain from any significant movements in the stocks that they invest in or concentrate their holdings to two or three sectors. A large number of these funds falls in the above-average category of risk, typically measured by the volatility in their returns (standard deviation) and the risk of the portfolio (the beta). So, FMCG and pharma funds have a comparatively lower standard deviation and beta, owing to the low volatility and risk of the underlying stocks.

The beta of ITC, an FMCG company, is 0.5, compared to a beta of 1.6 for Reliance Infrastructure when measured against the Sensex. So, for a 10% fall in the Sensex, Reliance Infra will fall 16%, while ITC will fall only 5%. But Reliance Infra (and other funds with high standard deviation and beta) can also outperform the market. Only those investors who understand the nature of focused funds and can digest the higher volatility should take exposure to focused funds, adds Agnihotri. Focused funds also tend to have a higher expense ratio of around 2.5% compared to 1.5-2% of diversified equity funds.

SHOULD YOU INVEST? According to experts, you can invest 10-15% of your portfolio in focused funds to lend dynamism to it, with a minimum investment horizon of threefive years. An SIP route is better for investors with a regular flow of income; if you are looking at a lumpsum investment, Rajesh recommends a 50% allocation at current levels and the balance to be invested on a correction in the market. She suggests the capital goods, IT, energy and metals sectors. "Valuations of many stocks in these sectors have come off their highs and present an improving outlook, she says.

Agnihotri believes investors could derive higher returns from sectors such as infrastructure, power and auto. Stock market veteran Shankar Sharma, director, First Global, is an ardent supporter of a sectoral strategy. Cement and auto are his top picks, and he believes investors could earn 25-40% returns. Before you invest, however, remember that focused funds carry an inherently higher risk than diversified funds.

Reproduced From Money Today. Copyright 2009. LMIL. All rights reserved.

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Publication:Money Today (New Delhi, India)
Date:Oct 1, 2009
Words:1007
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