Avoid Sectoral & Thematic Funds in These Volatile Times

However, on the contrary, equity mutual funds have remained appealing to some investors despite stock market volatility and the uncertainty produced by the Russia-Ukraine conflict, rising interest rates, and high inflation. According to the data issued by the Association of Mutual Funds in India (AMFI), investment in equity mutual funds stood at Rs 15,890 crore in April 2022, and an investment of Rs 18,259 crore has been received in May; the largest share in this has been Systematic Investment Plan (SIP).

AMFI chief executive Mr N. S. Venkatesh said, "Retail investors of mutual funds opted for SIPs in equity and hybrid asset classes for their long-term investments. The confidence of retail investors in the equity asset class reflects the fact that India's growth story continues and is more solid and opportunity-oriented than other major economies. The Reserve Bank of India has projected India's GDP growth at 7.2% cent, despite rising inflation and interest rates and challenging macro-economic conditions. The exposure to Indian equities by domestic institutional investors has been excellent, even though there has been a sell-off by foreign institutional investors."

Despite significant market volatility and lower returns from several equity fund categories, the Indian equities market remains an attractive investment opportunity for emerging market investors. This reflects the positive sentiment among the investors.

Given that, making investment decisions by timing the market is not a good idea. When it comes to avoiding risky equity mutual funds, making investment decisions based on current or short-term market trends can lead to undesirable investments over time. You may be correct on occasion, but you may also be incorrect. Notably, a mutual fund scheme's past performance does not indicate its future performance. However, investors continue to chase historical returns, especially when it comes to sectoral or thematic funds.

According to Peter Lynch, "If you are in the right sector at the right time, you can make a lot of money very fast". Time and again, due to the impact of economic cycles, some sectors tend to perform comparatively well and thus are capable of beating the market returns. This occurrence is not restricted to longer time frames.

Equity markets have been highly volatile due to a wide range of factors. The Russia-Ukraine crisis has caused Brent crude oil prices to surge, and India is heavily reliant on oil imports. Brent crude oil is currently trading at $113 per barrel in year-to-date terms. Gas prices have also risen as a result of the ongoing conflict, which has disrupted Russian supply. The increased energy costs will help the stocks of firms that produce crude oil and gas, such as ONGC, Indian Oil, Gail, etc. As a result, sectoral funds that own such equities will earn optimal returns.

However, it is impossible to take a call on all sectors uniformly. For example, before the industry was afflicted by regulatory challenges in the global market, pharmaceutical plans were thought to be a defensive sector. The pandemic of COVID-19 boosted the industry even further. The IT sector, too, saw a major upgrade as a result of the pandemic. In an increasingly digital context, the sector was expected to benefit greatly from IT modernisation. Many mutual fund investors believe these IT sector-focused mutual funds are safe to invest in, based on the sector's consistent performance. The current volatility, however, is putting all of these theories to the test.

So, does it make sense for retail investors to make sector-specific bets through sectoral mutual funds? Or Should they opt for diversified mutual funds instead?

A sectoral fund invests in firms that are parts of a specific industry or sector, such as technology, banking, pharmaceuticals, natural resources, information technology, real estate, and energy. According to SEBI standards, sector mutual funds must invest at least 80% of their assets in equity and equity-related securities of that sector. Thematic funds, on the other hand, invest in stocks that are tightly focused on a single business opportunity. These might look similar to sector funds but may consist of several sectors. Although thematic funds are more diversified than sector funds, they are still entirely dependent on one particular investment theme.

For instance, the technology sector fund will consist of companies like Infosys, Wipro, TCS, and HCL. Similarly, a pharma sector fund will invest in companies like Cipla, Johnson & Johnson, and Sun Pharma. Whereas under thematic funds, the consumption theme would include numerous sectors such as FMCG, consumer durables, textiles, and leisure. The financial service's theme will include banking, insurance, and NBFCs sector. These sectoral and thematic funds invest in companies of all sizes - large-caps, mid-caps and small-caps. The only mandate is that they should belong to the same sector or theme.

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These mutual funds offer significant returns, but only if the timing of the investment is precise. It is critical to invest in sector-specific funds at the right time. This is due to the fact that sectors follow the business cycle, and the fund is affected by the cycle's ups and downs. Investing in high-growth sectors can result in potentially high profits. However, if the sector goes out of favour, it can lead to significant losses as well. It is mainly due to the lack of diversification. Sector funds are a possible way to enhance a portfolio. However, one has to be patient enough to go through the market cycles.

Keep the following points in mind before investing in the Sector or Thematic Funds:

• Sector and thematic funds are suitable for those who have a thorough understanding and in-depth knowledge of a specific sector or theme.

• Sector funds are intended to be held for a medium to a long period of time. Short-term investments are risky. Furthermore, investments should be made for a defined period. As sectors have a cyclic pattern.

• Beware that timing your exit is essential, especially when investing in sector funds, which are cyclical by nature. As a result, for this, a thorough market analysis is required.

• When investing in a sector or thematic fund, don't rely on historical performance. Instead, look closely at the upcoming opportunities in that sector or theme.

• Highly risky as Sectoral mutual funds pertain to one particular industry and have no scope for diversification. Hence these funds can be riskier than other mutual funds.

• It is advisable first to have a diversified portfolio comprising regular mutual fund schemes. Sector and thematic funds are known for their higher risk and volatility. Ideally, not more than 5-10% of the portfolio should be allocated to sectoral or thematic funds; it will be a considerable risk for any investor.

To conclude...

Sectors go through several business cycles, which have an impact on the overall performance of the companies that belong to the sector. Thus, based on your research and analysis, you have a chance of making exceptional returns if you can catch the right cycle by investing in sectoral funds.

Remember Warren Buffet's advice: "Never invest in a business you cannot understand." Investors should invest in sector funds only if they understand the aim and the theme of the fund and have confidence in a particular sector. Sectoral mutual funds are not suitable for all investors; they are high-risk, high-return investments. Furthermore, any incorrect forecasting of market circumstances and growth trends can result in significant losses. Sector fund investment best suits investors with a better understanding of risk. This investment is suitable for investors with a long investment horizon of 5-7 years or more. Active investors who keep up with the latest news and headlines can make better predictions about which sectors will do well.

The market is likely to retain the intensified volatility in the near term, given the headwinds in play. The liquidity conditions in the market may also be squeezed. It means easy money is not going to chase every stock in the market, and this will keep the market on a tight leash.

As a result, you should first evaluate how much exposure to any sectoral or thematic funds is healthy for your investment portfolio. You should invest in sector funds only and only if you are well aware and able to predict a good cycle for that sector and if you are comfortable with its volatility. Alternatively, you may consider diversified equity mutual funds, which typically invest across sectors that are performing well, so you won't lose out on a sector investment opportunity. For pure sector-specific bets, these are good alternatives.

Ensure that you invest in worthy mutual fund schemes as per your suitability based on your risk profile, investment horizon and objectives.

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Warm Regards,
Mitali Dhoke
Jr. Research Analyst