What are Sector Mutual Funds
Sector or sectoral mutual funds are a subcategory of equity funds. According to SEBI, these funds must invest at least 80% of their total assets in equity and equity-related instruments of a specific sector. This means that if you’re investing in, say, a banking and financial services fund, 80% or more of your money will be allocated to the stocks of banks and financial institutions, such as SBI, HDFC, and Axis Bank. Similarly, if you invest in a pharma and healthcare fund, over 80% of the investment will be allocated to companies such as Sun Pharma, Cipla, and Max Healthcare.
The main goal of sector funds is to capitalise on specific sectors like technology, infrastructure, FMCG, and energy. This is different from other equity funds like large and midcap funds which spread investments across various market caps and sectors to reduce risk and ensure wider market exposure. This concentrated approach of sectoral funds meaning the focus on a single sector is their defining characteristic. These funds can perform very well when the chosen sector is doing great, but this very same exposure can also lead to significant losses if the sector underperforms. That’s why a mutual fund advisor usually recommends sector funds only to experienced investors who can withstand market volatility and understand the cyclical nature of sectors.
Features of a Sector Fund
Some defining attributes of sectoral mutual funds include:
Concentrated Approach
The universe of stocks in sector funds is limited to companies within a specific industry which makes the fund’s portfolio inherently concentrated. That does not mean sector funds aren’t diversified, their portfolios contain many different stocks from within the sector.
High Risk-Reward Tradeoff
Due to the concentrated portfolio, you can make serious gains when the sector performs well, but you’ll also be exposed to higher risk if it does not. For this reason, a financial consultant may recommend such funds only to those who can bear to take losses even if the overall market is doing well.
Require More Due Diligence
To invest in sector funds, it’s important for investors to understand where the sector currently stands in its cycle. Certain sectors are associated with market cycles, meaning different periods in the economic cycle favour different industries. For example, sectors such as FMCG tend to be more stable across different market cycles, whereas the automotive industry is more cyclical in nature. Understanding these cycles can help you identify the right time to enter or exit a sector fund, making timing an important factor as well.
Types of Sector Funds
Now that you know what is a sector fund, check out some of its types:
Actively Managed Sectoral Funds
These are the most commonly found sectoral mutual funds. Here the fund manager adds value by identifying the best-performing companies, adjusting asset allocations based on market trends, and managing risks. The main goal of such funds is to outperform the sector benchmark through comprehensive research.
Passive Sectoral Funds
These funds track a specific sector index such as the NIFTY Bank Index. There’s no active decision-making involved, so these funds simply mirror the index by investing in the same stocks and giving them the same weightage as the index. That’s why the expense ratio of these funds tends to be lower compared to actively managed ones.
Sectoral Thematic Funds
As the name suggests, sectoral thematic funds invest across multiple sectors but they must adhere to a common theme that ties the portfolio together. For example, an ESG fund invests in companies across sectors like energy, technology, manufacturing, and finance, but only if they meet specific ESG (Environmental, Social, and Governance) scores. These scores depend on factors like low carbon footprint, good employee treatment, promoting sustainable practices, and making environmentally and socially conscious decisions.
Funds Depending On The Sector
Sector funds can be further classified based on the type of sector they invest in. These can include:
- Infrastructure Funds
- Healthcare Funds
- Transportation Funds
- Technology Funds
- Banking and Financial Services Funds
- FMCG Funds
- Manufacturing Funds
How Does a Sector Mutual Fund Work?
A sector fund works just like any other mutual fund in the sense that it pools money from multiple investors and invests it in a diversified manner on their behalf. The key difference lies in where that money is invested. Diversified equity funds spread the investment across various sectors, but a sector fund channels most of its capital into a single sector. The fund manager thoroughly researches the sector and selects companies within it with good fundamentals and growth potential.
Though most sectoral mutual funds are actively managed, some follow a particular sectoral benchmark such as the NIFTY Bank Index or the BSE Healthcare TRI. These sector funds are classified as index funds, and they aim to replicate the performance of the benchmark by investing in the same stocks, in the same weight, and without any active management by a fund manager.
Benefits of Investing in Sector Funds
Advantages of investing in sectoral mutual funds include:
- Potentially Very High Returns: Since sector funds target a specific sector, your returns can shoot up if the sector booms.
- Diversified Portfolio: Even though sectoral funds aren’t as diversified as other equity funds, they still invest in about 30 to 40 different stocks, thus reducing some risk.
- Opportunity To Exploit Trends: Macroeconomic trends, geopolitical events, and government policies can present opportunities for investors. Sector funds are well-positioned to take advantage of these changes. For example, if governmental policies indicate a focus on green energy, sector funds that invest in companies offering renewable energy, electric vehicles, and good ESG compliance can benefit. Similarly, during wars and conflicts sectors such as defence can experience a surge in demand, and thus, profitability.
- A Good Way To Diversify Portfolios: For investors with a high-risk tolerance, an appropriate allocation to sector funds can be a great way to diversify their investment portfolio.
How Should You Invest in a Sector Mutual Fund?
Assess Your Risk Profile And Goals
Before you invest in sectoral mutual funds, understand whether or not they would suit your financial goals and risk profile. These funds are often considered the riskiest category within equity mutual funds, so assessing their suitability is pivotal.
Identify Sectors
Then, you must pick out promising sectors to target by analysing economic cycles, past and current trends, risks, growth potential, global events, government policies, and valuation metrics.
Select The Funds
The choice of funds should depend on factors such as:
- Past performance
- AMC’s reputation and AUM
- Fund manager’s expertise
- The benchmark’s past returns
- Expense ratio
- Risk-adjusted returns (Sharpe ratio, beta, Treynor ratio, etc.)
The best sector mutual funds are not just those which score well on these parameters but also those that align well with your risk profile, investment horizon, and financial goals.
Choose Between Lump Sum and SIP
Like any other fund, sectoral funds give you the option to invest with either a one-time lump sum amount or through Systematic Investment Plans. Select the option that best aligns with your income and begin investing. You can check out our sip investment planner, and set different monthly amounts and expected returns to visualise how your investment could grow over time.
Monitor Your Investment
If the fund is sensitive to market cycles and other macroeconomic factors, you should ensure conducting regular reviews of its performance. Sectoral funds can bring along profitable opportunities, but it is equally important to understand when to exit should circumstances change. A professional can guide you in selecting the top sector mutual funds that align with your goals, risk profile, and market outlook and also help you plan your entry and exit strategies to make the most of your investment.
Why Should You Invest in Sector Mutual Funds?
If you have a high-risk appetite and also understand macro trends, you can consider giving sector funds an appropriate allocation, and take advantage of sector-specific opportunities. During favourable sector phases, you’re likely to get the potential to earn significantly higher returns compared to other equity fund categories, especially if you’ve identified a sector that promises strong growth. A mutual fund investment planner can help you identify sectors which are likely to do well in the coming years and guide you in choosing funds that align with your financial profile.
Investing in sectoral thematic funds also gives you the chance to diversify your portfolio thematically and align your investments with trends you believe in. For example, if you’re someone who only wants to invest in companies which positively impact the environment, you can consider ESG thematic funds. Similarly, if you believe in the growth of the digital economy, you can explore digital India funds, and invest in technology-driven companies.
Taxation Rules of Sector Mutual Funds
Since sectoral mutual funds invest more than 65% of their resources in equities and related instruments, they receive the equity tax treatment.
Capital Gains Taxation
Capital gains are profits made when the investment is redeemed.
- Long-term Capital Gains Tax: Earnings are categorised as LTCG only when you sell your sector funds after holding them for more than 12 months. In this case, LTCG tax is charged at 12.5%, but only if the total LTCG across all equity investments exceeds Rs. 1.25 lakh in a financial year. For example, if your LTCG in a particular year was Rs. 2 lakh, then Rs. 1.25 lakh would be tax-exempt, and the remaining Rs. 75,000 would be taxed at 12.5%.
- Short-term Capital Gains Tax: If you sell your units within 12 months of purchase, any gains made are termed STCG and are taxed at 20%.
Timing is an important factor when investing in sector funds, so entering or exiting them at the wrong time could not only affect your returns but also increase your tax liability. A professional tax consultant can guide you on the most tax-efficient way to redeem your investments and make sure you don’t end up paying any more tax than you owe.
Dividend Taxation
Dividends from IDCW plans are taxed in your hands according to your income tax slab. Plus, if your dividends exceed Rs.5,000, the AMC will deduct a TDS of 10% under Section 194K before crediting the amount.
That’s why a tax planner might suggest growth plans over IDCW plans, as the growth option is considered more tax-efficient for investors, especially those in higher tax brackets. In growth plans, your money stays invested, and you pay capital gains tax only when you redeem your units. If you stay invested for more than 1 year, you can take advantage of long-term capital gains tax benefits (exemption plus lower tax rate).
Considerations Before Investing in Sectoral Mutual Funds
There are some things you should keep in mind before investing in sectoral mutual funds:
High Risk Investment
Sectoral funds are inherently high-risk vehicles as they concentrate investments in a single sector. If your chosen sector underperforms, your returns could take a massive hit. Be sure to check the fund’s top holdings and understand how diversified it is within the sector.
Compare Funds Within the Same Sector
It’s said that you should always compare funds within the same category, but since sector funds are concentrated in specific industries, this becomes even more important. Each sector behaves differently based on macro factors, which is why comparing a pharma fund to a banking fund won’t give you much meaningful information. Understand the factors that drive different sectors to avoid unnecessary risks.
Compare Funds Against The Benchmark
Every sector fund follows an index such as NIFTY FMCG and NIFTY Energy. It’s important for investors to look past just absolute returns and compare how well, and how consistently a fund has performed compared to its benchmark. Active managed sectoral funds come with higher fees, so you want to make sure that fund managers are actually adding value with their decisions.
Timing Is Important
Some sectors move in cycles, so having precise entry and exit timing strategies is essential to maximise returns. A sector might perform brilliantly for a couple of years and a new investor might think it’s a great long-term bet, only to invest just when the sector is about to slow down. If you’re not confident in doing this yourself, you should consider working with an online financial advisor india who can monitor market conditions and recommend timely adjustments.
Higher Expense Ratios
Actively managed sectoral funds generally come with higher expense ratios compared to index funds or other equity funds. Compare expense ratios across different funds and make sure that the fund manager’s expertise justifies the higher costs.
Not Ideal For Novice Investors
If you’re new to investing, sector funds may not be the ideal place to start. These funds are risky and dependent on market cycles, so they demand a higher level of knowledge and understanding compared to other types of mutual funds. If you are confident about a particular sector, maybe because you work in it or closely follow its trends, you can consider investing in it. But even then, it’s a good idea to take the help of an investment advisor who can guide you on selecting the right fund, entry point, allocation amount, and when to exit.
Conclusion
A sector fund is a type of equity mutual fund which concentrates its investments in a specific sector, such as banking, IT, or FMCG. This approach gives you the potential for earning high returns when the sector is performing well but it also comes with higher risks. Usually, sector funds are chosen by investors with high-risk tolerance as a way to diversify their portfolio and make focused bets on sectors they believe will perform well.
