How you should use sector funds

Who wouldn’t like a return of 133% in a year for a fund, at a time when many other funds delivered less than half of that? This kind of bumper returns typically come by in a particular class of equity funds – sector funds. In this case, the fund in question is ICICI Pru Commodities. Therefore, it’s fairly obvious that sector funds and thematic funds can offer a good avenue to boost returns. Another plus is that these funds give you some control over which sector to hold, based on where you think opportunities are – unlike other equity funds where sector allocations are based on fund manager views.

But these are not funds that will suit all of you, even if you think long term. The approach you take for these funds, the allocation you make, the way you select, all matter in how effective these funds will be for your portfolio. In this article, we’ll explain the best way to go about using sector funds in your portfolio.

What sector funds or thematic funds are

Before getting deeper into fund usage or selections, it’s important to understand the nature of sector or thematic funds. All such funds are clubbed together under SEBI’s ‘Sector/ Thematic’ category. However, there’s a great deal of difference between funds.

• Sector funds in their purest form focus on a single sector. This could be financial services, IT, or pharmaceuticals, for example. These funds hold the highest risk since sectors come into and fall out of favour in each market cycle, and the fund’s entire return potential depends on its sector doing well.
• Thematic funds are broader than pure sector funds. These funds pick stocks based on a particular theme. They comprise multiple sectors that satisfy the contours of the theme. Infrastructure, for example, is a theme that can cover construction, cement, metals, engineering, or oil & gas. However, note that the sectors a theme can cover may not always be straightforward. For example, several infrastructure funds hold banking as banks provide the lifeline of funding infrastructure projects. Therefore, you need to  look at portfolios over a few months or across a few funds to understand the range of sectors the theme could cover. The broader nature of these funds makes them marginally less risky than pure sector funds.
• Some themes can be vaguely defined, which makes it harder to work out where funds may invest. These themes can also make funds similar to normal diversified equity funds (i.e., multicap, flexicap, value funds etc). For instance, an ‘opportunities’ or ‘disruptors’ theme can mean any stock or any sector. It could be value stocks, it could be growth stocks. In the same vein, a business cycles theme or an ESG theme can be very broad in terms of the investment universe. This is important because, when evaluating these themes, comparing them against normal equity funds will give you a better picture of that theme’s performance. These broader themes also may not offer the type of outstanding returns that more focused themes or sectors can give. For example, ESG funds have delivered returns similar or even less than the Nifty 500 index based on 1-year returns. 
• International funds can be thematic or sector-based as well. Gold mining, energy, or water, for example, are thematic, unlike a Nasdaq 100. These are even trickier than domestic thematic or sector funds because they call for an understanding of global sector movements and prospects.

Types of themes or sectors

The classification of sectors and themes is useful because it indicates the level of risk you’re taking, the tracking of performance that you need to do, the need for timing entry or exit, the role that fund will play in your portfolio and the allocations you need to make. Now, there are some themes and sectors that require more timing and those which are longer-term in nature. 
We’ve briefly outlined the nature of the more popular themes and sectors below. Do note that this is not an exhaustive list.

Timing-based

Obviously, the ones that are timing-specific carry higher risks. Simply holding on to these funds for years together does not guarantee a turnaround. Such funds carry higher risk even within the sector/thematic space.

1. Banking & financial services: Banking forms about a third of the Nifty 500 and has expanded to include sectors such as insurance or AMCs. But banks and NBFCs go through cycles based on economy and corporate growth and can be more volatile. The sector is also the dominant one for most diversified equity funds. Therefore, timing an entry and booking profits will better-help capture returns.
2. Infrastructure: While this theme encompasses several sectors, they all share cyclicality. Infra can fall right out of market favour and stay that way for a very long period, as has happened earlier. Even within the space, the stocks that come up in each cycle may be different. In a similar vein, manufacturing as a theme also does require timing due to the cyclical nature of most sectors the theme covers.
3. Commodities: Commodities could mean agri-commodities or metals or even cement and energy. Each commodity goes through a cycle where prices rise and fall based on demand and supply. Most metals and agri-commodities also have a global factor at play. Timing entry when the cycle is down is the key to capturing the recovery. 
4. Pharmaceuticals: Healthcare treads the line between the need for timing and a longer-term holding. While pharmaceuticals and healthcare are relatively secular plays, they can go through sustained periods where they lag other sectors. Funds in this space are also often concentrated in their top holdings and any dip in these holdings can mean poorer returns. Therefore, while pharma as a sector can be held for years together, some amount of profit booking from time to time, based on the extent its allocation has moved in your portfolio, may be needed.
5. PSU: Depending on the stocks the fund holds, PSU funds can spend lengthy periods of time lagging the market. While many PSUs would score on valuation metrics, regulatory overhang can keep them out of market favour.

Longer-term

Longer-term themes and sectors are those which can form part of long-term portfolios and which you can accumulate over time. However, this does not mean they are low on risk – all that we’re saying is that these funds can be held over a longer timeframe and dips in returns aren’t as alarming as those discussed above. Running SIPs in these funds – especially when they are a broader theme – may also work.

1. Consumption: Like pharmaceuticals, consumption also treads a line between long-term and timing. However, what works in consumption’s favour is the sheer vastness of its application – anything that people would consume whether it is apparel, entertainment, food, loans, jewellery, paints, tiles, investments or loans all are lumped under consumption. Two, it’s more ‘defensive’ nature helps in times of correction. 
2. Software: The changing nature of the sector itself, domestically and globally, works in favour of IT being a long-term theme especially at this time. IT also tends to be under-owned by other equity funds outside the bigger large-cap names. Like consumption, IT also dons a defensive role.
3. MNC: The idea behind MNCs is that they feature companies that score on metrics such as low debt, good corporate governance, overseas parent backing and strong balance sheets. However, funds themselves are an eclectic mix of stocks across sectors and to this extent are quite different from most equity funds. However, they work more to contain downsides than really participate in rallies.
4. Opportunities: By this, we mean anything from special situations to business cycles to disruptors. All these themes are akin to bottom-up stock picking and are usually agnostic to sectors and benchmarks. Essentially, these themes are very similar to what diversified funds do. Thus, what these funds offer is good style differentiation for long-term portfolios. We have, for example, an ‘opportunities’ fund in our Prime Funds – not in the thematic section but in the Equity Aggressive section. Because they can be similar to normal equity funds, their risk goes down a few pegs compared to sector or narrower thematic funds.
5. Quant and ESG: Quant funds are good at keeping downsides contained but may not be able to capture rallies especially during long bull runs. Theoretically, both the quant and ESG themes are long-term plays and have very different strategies compared to other equity funds – especially quant. In the Indian context, though, neither theme has enough of a record to judge performance. Therefore, treat these funds with caution, and make small allocations, if at all. 

A brief summary is outlined below.

This concludes the basics you must know about sectors and themes. Now, how do you approach them for your own portfolio?

Two approaches to thematic or sector funds

First, ask yourself whether you even need sector or thematic funds. You assume that these funds can add zing to portfolio returns. 

However, choosing the wrong themes or sectors can weigh returns down instead of spicing them up. Second, while a theme or sector may do very well, in some market cycles they could well be eclipsed by diversified equity funds. For example, IT as a sector has worked very well in the current market rally. But several mid-cap or small-cap funds have delivered even higher returns. Third, as mentioned above, broader themes such as special opportunities, ESG, quant, and so on may not deliver significantly higher than market returns. 

Therefore, look at your own portfolio and what you need. 

If your portfolio is not large – less than Rs 15-20 lakh – consider skipping sector or thematic funds. This portfolio size is not large enough to need the kind of diversification that thematic/sector funds offer. The usual mix of equity and debt funds spanning market cap segments and investment styles (and international funds that are not thematic) will suffice to give you a rounded portfolio. Including thematic/sector funds is likely to only increase the number of funds you need to track and complicate your portfolio. More importantly, mistimed sector calls will have a higher impact on returns.

Portfolio diversifier

The first way to use sector/thematic funds is as portfolio addition to offer differentiated returns. By this, we mean that your aim is not to drive overall portfolio returns through such funds. It is to offer a counter or introduce a different fund style to your existing equity funds.

Nature of approach: The intent here is to pick funds that don’t drastically increase the portfolio’s risk profile or which can balance the other equity funds you hold. To this end:

• Go for thematic funds that cover different market segments. This increases the pockets of opportunities you’re tapping and reduces the overall risk you take. Unless you have the confidence, avoid sectors where timing is the key.
• Funds in the ‘Opportunities’ theme explained in the previous section can be good fits as they feature a disparate set of stocks with no leaning towards any particular sector.
• Keep the allocation to a maximum of 15% and use 2-3 funds. You can mix a narrow theme and a broader one for a better balance.

Suitability of approach: Using thematic funds as diversifiers is useful where your portfolio will benefit from diversification, such as very large portfolios where you already have a good mix of normal diversified equity funds and individual fund exposure is already high at about 10-12%. The approach is also useful where you do not have the experience or time to track markets and themes and for moderate-risk investors. Finally, if you own a direct stock portfolio outside your mutual fund portfolio, diversified thematic funds will offer a good foil.

Portfolio return kicker

The second approach is to build a set of funds outside your core portfolio to introduce a high-return component. This approach means that you have to necessarily track markets and funds to know which to invest in and when. 

Nature of approach: This approach is a high-risk one that you can take if you are a seasoned investor. You need to have a more hands-on approach and actively track performance. To this end:

• Keep your core portfolio a balanced mix of large-cap-oriented funds, debt funds and mid-cap/small-cap funds. Don’t go for very aggressive funds here as you are taking up that mantle in your thematic/sector funds.
• In choosing sectors or themes, aim for those that your core equity funds aren’t already overweight on. Most large-cap oriented funds, for example, are big on banking and finance. But sectors such as pharma or infrastructure or even consumer-based may be far less dominant. If you do choose financial services, timing becomes even more important because any hit will impact both your core and your add-on funds.
• Fund allocations need to be concentrated if you are to make gains (and to this extent, it won’t fit our 10-15% cap that we normally suggest for such funds). Therefore, make sure that you book profits from time to time – even if the sector/theme has steam left - to preserve returns. Be aware of the risk you are undertaking and try to spread investments across at least 2-3 sectors/ themes.
• You can consider a mix of longer-term and shorter-term sectors or themes. You could even look at international themes, of which there are a few options in the domestic fund space. If you are specifically looking for outsized returns, avoid diversified themes for this purpose.

A more extreme variation of this approach is to build a portfolio made of sector/thematic funds and churn the sectors based on market potential. This, however, involves far more tracking of markets and needs understanding across sectors and macro-level factors. At PrimeInvestor, we are exploring the idea of creating portfolios like these – but let’s see how and when it shapes up!

Suitability of approach: This approach is only for the very high-risk investors, with both time and ability to keep track of portfolio and market performance.

Picking sector funds

Unfortunately, there is no straight answer here. You need to know which sectors are doing well, and for that you need to be aware of market trends. What we can tell you is this:

• One, avoid picking funds because their 1-year or recent returns are high. High returns means that the theme has already been delivered. It doesn’t mean the fund is good now unless the theme still holds promise. 
• Two, within a theme/sector, look at the holdings in the fund portfolios and weigh  them against your own take on that sector or theme; fund portfolios within a sector/theme range from being very similar to very dissimilar. Where available, a look at past performance will offer some idea of how well that fund has done in capturing earlier rallies and how much it has fallen. But with sector/theme funds, it’s not essential that you only go for funds with a long track record.
• Three, if you’re bullish on a theme/sector, look at Theme Park – here, we pick the funds that are most suited to play that theme. So, if you do the homework on which sector you want to invest in, we do the work on analysing which fund works best.

Of course, if you have absolutely no idea about sectors at all and you still want to invest, refer to the Strategy/ Thematic section in Prime Funds and read the ‘Why This Fund’ to know about it. 

However, if you wish to use thematic or sector funds, always be aware that they are high-risk and not for everyone.