Returns from these funds can be higher in the long run but watch out for volatility, which can be more than diversified mutual funds or index funds

Judging by the positive reaction to the recently launched Central Public Sector Enterprise (CPSE) Exchange Traded Fund, a lay investor may be forgiven for assuming that sector funds or thematic funds are back in favour. Sure, this product is being marketed as an instrument that will allow retail investors to take exposure to highly rated public sector corporations.

This is probably the only reason that is working in its favour. Most stocks in that ETF sport a good dividend paying record, although it has a higher weighting to the energy sector. Holding for the long term may help people reap the benefits of this ETF. But, given the diverse nature of the stocks, the ETF is any but sector- based. It's a thematic fund based on sound dividend paying public sector units.

Nevertheless, the spotlight is now on sector funds. The returns from the stock markets in 2013 seem to suggest that investing in certain sectors can provide larger profits than investing in diversified funds. Many diversified funds have undershot the eight per cent gain in the Sensex last year.

A case for concentrated portfolios

In equity markets, two categories of funds outperformed all other asset classes by a huge margin — the technology sector, which comprises IT and allied industries, and the pharmaceutical sector. While the former raked in close to 46 per cent returns, the pharma sector came a close second with 32 per cent. Does this make a case for investing in sectorial funds? Should investors make highly concentrated bets? Sector funds invest in stocks of a particular sector such as FMCG, pharma, banking and so on. For example, a pharma fund will invest in healthcare stocks such as Cipla, Sun Pharma and a banking fund will invest only in stocks such as SBI, ICICI Bank, HDFC Bank and so on. Given the narrow mandate and focus, a fund manager has restricted the number of stocks in a particular sector to choose from. Because of this, a sector fund consists of fewer stocks compared to a diversified equity fund. Often the size of most sector funds is less than ₹ 100 crore. This could result in a high expense ratio for an investor.

Not much choice with ETFs

Investors also have the choice of Exchange Traded Funds (ETFs) which also represent a particular index such as Nifty, Banking, etc. The most important aspect here is the expense ratio, which is less than 0.70 per cent compared to sector funds offered by mutual funds that charge anywhere between 2.25 per cent and 3 per cent as annual fund- management expenses.

At present, ETFs do not offer as many choices among sectors as offered by mutual funds.

Hence, most investors prefer investing in mutual funds. Ideally, ETFs are recommended only for sophisticated investors. For retail investors, indexed ETFs are more suitable than sector ones.

Through various economic cycles, some sectors do well; others don't. Hence, this necessitates research by an investor before buying such funds. Sector funds have very high volatility compared to diversified equity funds and hence come up with nasty surprises if economic policies or business environment change the pattern for the sector.

Avoid flavours of the season

For example, during the last leg of the bull run in 2007, many AMCs had launched infrastructure funds banking on the growth in that sector expecting favourable government policies. After the markets tanked in 2008, many infrastructure funds lost heavily and, even after five years, many have still not recovered from the losses. Similarly, one cannot expect last year's performers — technology and pharma sectors — to continue providing high returns this year too.

For a first- time investor, diversified equity funds should be the first choice as someone new to the market may not be prepared for the volatility that dogs sector funds. Also, these funds should not be considered for your main financial goals such as children's education, retirement, etc. Your core portfolio should always comprise good diversified funds, which are less volatile and command a better long- term performance track record.

Look for diversification and balance

In diversified equity funds, one can stay for the long term as the best sectors in the economy would ideally be covered by such funds.

However, one needs to track sector funds more as fortunes of a particular sector may keep shifting over time. This might necessitate switching out of those funds before the situation is about to get worse. So, don't expect to hold these funds for the long term, though at times you may hold them for a fairly long period expecting the fortunes in that sector to improve.

Usually during a slowdown in the economy, defensive sectors such as FMCG and pharma typically tend to do better than other sectors while banking and infrastructure suffer. Similarly, the banking sector which fell by 13 per cent last year is expected to do well when the economy starts doing well.

This does not mean that you can predict tomorrow's winner easily. One needs to keep tabs on the changes in the economic and regulatory environment — and invest accordingly. For most, this would be a daunting task. Hence, avoid getting into sector funds. The lure of large returns can be a great pull; nevertheless, if you cannot track the sector's ups and downs, then you are better off investing in diversified equity funds or index ETFs. These offer you exposure to a diversified portfolio.

Don't go overboard. Restrict your exposureto sector funds to between 10 per cent and 20 per cent of your equity allocation — and ideally utilise the systematic investment plan route. And remember, review the sector regularly for any change in sentiment and outlook.

The quantum of dividend shall be Rs 0.0389 per unit. The record date has been fixed as April 03, 2014.