What are Sectoral Mutual Funds?

Introduction

A mutual fund is an investment vehicle that pools money from investors having a common investment objective. It allows for portfolio diversification in several ways. One can diversify their portfolio by investing in a particular economic sector. These funds are known as sector funds or sectoral mutual funds.

Sectoral Funds

As the name suggests, sectoral funds are mutual funds that invest in companies belonging to a specific industry or sector of the economy. These equity funds belong to companies with different market capitalisations, investment objectives, and security classes. 

Types of Sectoral Funds in India

To understand better what is a sector fund, let us study them under the following eight categories.

Utility Funds: Utility funds invest in utility companies that are engaged in the business of providing people and businesses with water, natural gas, electricity, sewage, and other similar services. Utility funds offer steady dividends to investors and are preferred by conservative fixed-income investors.

Financial Funds: These funds are invested in companies belonging to the financial sectors such as banking, insurance, mortgage, and accounting. 

Communications Funds: Funds are invested in companies involved in telecommunications, including those engaged in internet-related businesses.

Technology Funds: These funds are invested in the technology sector, which includes those involved in IT, computers, electronics, and related products and services. 

Real Estate Funds: Investors with a limited corpus can venture into the real estate sector by investing in real estate funds. These funds provide both income and growth opportunities to investors.

Natural Resources Funds: The natural resources sector is usually subject to long-term fluctuations and therefore suited for long-term investors. These funds are invested in oil and natural gas companies or those involved in timber-related industries and forestry. 

Precious Metals Funds: Investors can invest in companies dealing in precious metals like gold, silver, copper, palladium, and platinum.

Healthcare Funds: These funds are invested in pharmaceutical companies, for-profit medical institutions, pathological laboratories, and the like. 

Features

To have a detailed understanding of sectoral funds, let us go through some of its features.

• Unlike other mutual funds, sectoral funds offer limited diversification since the portfolio of investments includes companies belonging to almost exclusively the same sector.
• These are more suited to investments over the long term since industry-wide fluctuations do not generally happen over shorter intervals.
• Investment is expensive when compared to other categories of mutual funds.
• The limited diversification translates into higher risks because a downturn in a particular industry reflects poorly on the overall sectoral fund portfolio.
• Higher risks in sectoral funds can turn into higher returns if sustained growth in a specific sector in the fund is invested.

Benefits

• Sectoral funds provide lucrative returns in case the sector chosen by the investor performs exceptionally well. Thus high returns are good compensation for the high-risk factor in sector funds.For instance, the healthcare fund saw tremendous gains in the wake of the pandemic because of the pharmaceutical companies. Thus, a major advantage of a sectoral mutual fund is the high returns one can earn if the investments are properly timed.
• Market exposure is another significant benefit of sectoral funds since these funds are meant to provide representation to sectors not included in an investor's portfolio. 

Drawbacks

Apart from the advantage that sectoral funds offer, a few limitations should be considered before investing in a sectoral mutual fund. 

• Sectoral funds do not guarantee stable returns. These are highly risky because of limited diversification.
• Because of the concentration of investment in a single sector, the portfolio is badly affected, and steep losses are experienced if the chosen sector receives a blow. 
• To invest in a sectoral fund, one needs to have substantial knowledge of industry trends and performance over the past cycles to carefully analyse whether the investment would be fruitful in the specific sector.

Who Should Invest in a Sectoral Mutual Fund?

Sectoral mutual funds are not every investor's cup of tea. These funds are a suitable investment option for investors who fulfil the following criteria.

An Appetite for Risk 

A sectoral fund requires you to put all your eggs in one basket. This limited diversification concentrates your funds in a single industry. As much as the stakes are high in favour, they are also averse.

Thus, if an investor can afford to take such high risks, they should only invest in a sector fund that is one of the riskiest mutual funds.

Industry Information and Experience 

Sectoral funds are highly unpredictable, and a sector is subject to cyclical fluctuations. An investor just starting might not be thorough about past performances of the different sectors and what the future holds for them.

But, seasoned investors are abreast with current news and updates regarding the sector and can make an informed analysis. Their investment decisions are strategic and not based on mere exuberance. Industry insights are another plus for investors involved in a particular industry, and they can predict future growth prospects for their sector.

Strategic Allocation 

Investors who have the relevant expertise and knowledge to time the business cycles can fetch substantial gains by investing in a business that is at its low and book profits as soon as they reach the peak of the cycle.

But, with great returns comes even greater risk. Therefore, sectoral funds are suitable for investors willing to take high risks and adept with industry insights. 

How Should You Invest?

You should keep a few things in mind when investing in a sectoral fund. Firstly, invest when the cycle is about to begin or when it is just getting started. That way, you can stay invested longer during the up-cycle. When you invest towards the end of the cycle when the gains have almost reached the peak, it will not offer much gain.

Investing in steep prices is not only expensive but also not very beneficial. Secondly, sector funds should not constitute more than 10-15% of your portfolio. The idea is to diversify yet have an edge in reaping gains from growth in a particular sector. Overexposing funds to highly unstable sector funds defeats the purpose of mutual fund investment and, therefore, is not prudent.

Thirdly, having a stop loss in mind will enable you to exit the sector fund when you cannot afford to stay invested any longer. It acts as a cushion against uncertain losses. 

Things to Consider Before Investing in a Sectoral Mutual Fund

You should undertake the following consideration before investing in a sectoral fund.

• Think of it as a long-term investment because, over the short term, it is very unlikely that a sector will reach its highest within a short period. Even if there is a positive trend, it might not make the sector grow leaps and bounds. 
• The association of high risks in sectoral funds is why seasoned investors prefer these funds. Unless you are confident to concentrate your investments in a single sector and not diversify your portfolio for a better risk spread, sector funds are not suitable for you.
• Weigh the expenses and incomes wisely. One expense can be in the form of an expense ratio charged by asset management companies for their administrative services. Therefore, to maximise your gains, you should minimise the expenses simultaneously.

Tax Implications

Sectoral funds are taxed as Short Term Capital Gains (STCG) or Long Term Capital Gains (LTCG) based on the investment period. If the investment were sold within one financial year, meaning in the short term, then the capital gains are taxed at 15% as STCG.

If the investments were sold after one year, meaning in the long term, they are taxed as LTCG at 10%. Gains up to a maximum of one lakh are exempt from capital gains tax.

Top 10 Best Sector Mutual Funds in India

Based on their performance over the last five years, the top 10 sectoral mutual funds in India, along with their risk profile, are as follows:

• Sundaram Rural and Consumption Fund (moderately high risk)
• Franklin Build India Fund (High Risk)
• DSP BlackRock Natural Resources and New Energy Fund (High Risk)
• IDFC Infrastructure Fund (High Risk)
• Aditya Birla Sun Life Banking And Financial Services Fund (High Risk)
• Kotak Infrastructure & Economic Reform Fund (High Risk)
• SBI Magnum COMMA Fund (High Risk)
• SBI Consumption Opportunities Fund (High Risk)
• Mirae Asset Great Consumer Fund (High Risk)
• Nippon India Power and Infra Fund (High Risk)

FAQs

How does a sectoral fund work?

An economy is composed of different sectors. At a given point in time, some sectors may perform well while others do not. A sectoral fund allows investors to capitalise on such opportunities and maximise returns by investing in sectors that are expected to perform well in the medium to long term.

The only requirement by SEBI is for fund managers of asset management companies to invest 80% of a fund's total assets in equity and equity-related instruments. 

Are sectoral mutual funds high-risk funds?

Sectoral funds invest in equities and are volatile over a short-term period. However, the best way to invest in sectoral funds as someone who does not have in-depth knowledge about the sector. One can opt for a long-term investment. This allows for risk spread.

What are some of the profitable sectors for mutual fund investment?

Healthcare, FMGC, infrastructure, and energy are some of the sought-after sectors in sectoral mutual funds investment. 

Why are sector funds riskier than other mutual fund investments?

The sectoral funds meaning indicates investment in one sector or one segment of the economy where there is very limited diversification. Hence, these are high-risk investments. The trade-off here is between high risk and high returns. If a sector is predicted to do well in the future, then investing in these sectors can bring in high returns.