FUND FLAVOUR

October 2014

The investors’ fancy with sector funds continues unabated. Despite the higher risk associated with sector funds (compared to diversified equity funds) investors choose to focus on the higher returns that sector funds have registered over the last couple of years. Sector mutual funds are those mutual funds that restrict their investments to a particular segment or sector of the economy. These funds concentrate on one industry such as infrastructure, banking, technology, automobile, heath care and pharmaceuticals, FMCG, PSU, etc. The idea is to allow investors to place bets on specific industries or sectors, which have strong growth potential. These funds tend to be more volatile than funds holding a diversified portfolio of securities in many industries. Such concentrated portfolios can produce tremendous gains or losses, depending on whether the chosen sector is in or out of favour. Sector mutual funds come in the high risk high reward category and are not suitable for investors having low risk appetite. Some investors choose sector funds when they believe that a specific sector will outperform the overall market, while others choose sector funds to hedge against other holdings in a portfolio. So, one should select sector mutual funds only when there is a positive road map to a sector.

Infrastructure Funds – back with a bang

The top performers in this category have given over 70% returns in the last one year. In the last six months, top funds in this category have given over 55% returns. The top performing infrastructure sector fund, in terms of last one year returns, Escorts Power and Energy (Growth Option), has given trailing return of nearly 85% in the last one year. While infrastructure sector funds, as a category, have outperformed diversified equity funds, it is important to note that, from a risk perspective, diversified equity funds offer more risk diversification compared to sector funds. Unlike diversified equity funds which aim to diversify unsystematic risks (i.e. stock specific and sector specific risks), infrastructure sector funds are exposed to sector specific risks. Infrastructure funds are affected by central government policies, either in a positive or in a negative way. These funds are also impacted in the short term by the monetary policy of the Reserve Bank of India. As such, investors with a short time horizon should stay away from infrastructure sector funds. However, for well-informed active investors, infrastructure sector funds can be good investment opportunities in the medium term.

Banking Funds – good long term prospects

Banking and Financial Services Sector has the highest weightage in both Sensex and Nifty. The performance of this sector is closely correlated with the overall economic growth in the country. Banking as a sector has underperformed with respect to the broader market over the last one year period. The returns, in fact, have been negative at -14.8% while the Sensex has delivered about 5.5%. Similarly the Bank Nifty, which is the NSE counterpart of the Bankex, has delivered -14.4%. The reason for the weak performance of this sector is well known. With economic slowdown the demand for credit has remained subdued. High inflation and interest rates have hurt the sector. The asset quality has worsened in this period, with increase in NPAs and write offs. However, from a long term viewpoint this sector presents attractive opportunities. There are also structural changes taking place in this sector. A set of new banks will get banking licenses from the RBI later this year. New norms of NPA recognition once implemented, will lead to improvement in asset quality in the future. As a result of these changes the health of the banking sector will surely improve. The returns of banking sector funds in the range of 25% to 40% in the past one year bears testimony to this fact.  

Technology Funds – stupendous show

The IT sector has outperformed the Sensex, on a consistent basis since July 2013. The primary reason for the outperformance has been the depreciation of the Rupee versus the US dollar which made the Indian IT sector competitive, in addition to the organic growth in dollar terms for the IT companies. In terms of returns, the BSE IT Index has delivered 43.7% returns in the last one year, while the Sensex has delivered only about 4.6%. It is only natural that savvy investors, invested in diversified equity funds may want to consider investing in IT sector focused funds to exploit the potential of superior returns. The IT sector funds have earned a return of 40% to 60% in the past one year. The future outlook of the IT sector remains very positive due to high current account deficit and lower capital inflows implying that the rupee will continue to be under pressure, which will ensure the continued competitiveness of the IT sector mutual funds in India.

Auto Funds – set to zoom

The automobile industry of any nation is a key indicator of its progress, and India is no different. According to estimates, this industry accounts for nearly 7% of India’s Gross Domestic Product and employs close to 1.9 crore people directly and indirectly. Research shows that India, which is the sixth largest automobile market in the world, is set to zoom ahead of its competitors in the near future. The UTI Transportation and Logistics Fund has earned more than double the benchmark index, a staggering 137% as against the benchmark return of 65%.

FMCG Funds – not out?

It is true that FMCG is a more secular sector as consumer goods will always see demand. Indian equity funds’ allocation to fast moving consumer goods (FMCG) is at nearly a four-year low. Once an over-owned sector amid economic uncertainty, it has slid in deployment of mutual funds’ equity assets. Data from the Securities and Exchange Board of India show allocations to FMCG stocks have dipped to 6.1% of equity assets, the lowest since September 2010. The current allocations to capital goods stocks is 3.3%, compared with 2.7% in January 2014. FMCG funds have been laggards in the last six months, with an average return of 5.32% against 12.13% offered by CNX Nifty, says Value Research, a mutual fund tracking entity. However, experts are not writing off the consumption theme due to the poor performance of FMCG segment. They continue to recommend investing in a broad-based consumption theme, which also includes FMCG. The strategy of sticking to a broad theme would help investors to tide over temporary blips, like the one witnessed in FMCG that is likely to occur from time to time. 

Pharma Funds – anti-ageing formula

Healthcare or Pharmaceuticals is a sector that has outperformed the broader market over the last one year period. In terms of returns, the BSE healthcare Index has delivered a very healthy 28.1% returns in the last one year, while the Sensex has delivered only about 4.6%. The one year returns of the pharma funds range from 50% to 65%.While the depreciation of the Rupee versus the US dollar has helped exports in this sector, the domestic pharma market growing at double digits, has resulted in strong revenue growth for companies in this sector. The pharma sector funds are often seen as an excellent defensive bet in weak market conditions. However, there are certain risks associated with this sector, primarily due to government regulations both overseas and in India. Headwinds are seen from the demanding US FDA guidelines, which may potentially impact exports, unless the companies are able to ensure compliance with the guidelines in their domestic manufacturing plants. The Indian government’s drug pricing policies have also impacted margins. Despite the headwinds, the future outlook of the sector remains positive due to high current account deficit and lower capital inflows implying that the rupee will continue to be under pressure, which will ensure the continued competitiveness of the sector. A number of drugs will go off patent in the next few years. This augurs well for the generics segment and the Indian pharma sector. The government also plans to increase health expenditure to 2.5% of the GDP by the end of the 12th Five-Year Plan (2012-17), which will give the sector another big boost. Changes in government policies, industry specific issues and technological developments may impact the healthcare sector, either in a positive or a negative way. Pharma and Health care sector has been evergreen and is expected to continue to do well in the next few years.

PSU Funds – patience pays

PSU funds are the funds where investment is made in Public Sector Undertakings. The PSU funds despite being thematic are not sectoral as they invest in PSUs across sectors and also across balance sheet sizes. So by investing in a PSU fund you are likely to get exposure to oil and natural gas, banking, power, thermal power etc. PSU funds were very popular in 2009-10 and then they lost favour with the investors. Since March 2014, the BSE PSU Index has surged by 61%. The index was in a lull between October 2010 and August 2013, when public sector firms were beaten down to rock-bottom valuations. Bargain hunting from September 2013 onwards propelled interest in public sector companies once again. The biggest factor that is driving these funds up is the change in Central Government which has boosted the market sentiment towards Government companies. Change at the centre is expected to improve the functioning of the PSUs and the new government is expected to take more industry friendly decisions. The functioning of the PSU companies has been improving over the past years and is expected to continue in the future too. Mutual fund investment should not be made only based on market sentiments but should also look at facts and figures, industry etc. The potential of privatization also makes them a hug attraction especially over the long term. Divestment is expected to make these companies more profitable owing to reduction in red tape and introduction of professional management. Another draw towards PSU funds is the expectation of reduction in the subsidy burden especially in the gas and petroleum segment which will increase profitability of companies like ONGC, GAIL, etc. If you invest in PSU funds be sure to adjust the rest of your portfolio accordingly.

In the long-run, you would be better off investing the majority of your corpus in diversified funds rather than in sector-specific funds. Diversified funds have significantly lower downside risks. Sector funds are subject to concentration risks – the fund’s returns may suffer if the sector does badly. In contrast, a diversified fund invests in a variety of sectors. Thus, even if a single sector fares badly, the fund’s returns may not be as severely affected as other sectors in the portfolio may outperform. As a matter of fact, in diversified funds, most fund managers continuously rebalance their portfolios and are overweight on sectors expected to outperform and underweight on poorly performing sectors. Let a sector fund be part of a tactical allocation. Avoid adding them in core family goals such as education or retirement. Restrict allocation to about 10% of your fund exposure at the most. Sectors such as FMCG and pharma can contain declines to some extent but not others such as infrastructure or banking. Hence, be aware of what to hold for a defensive strategy. If you believe you have made decent money simply exit and do not look back at opportunity lost. It takes more than an expert to time sectors. In conclusion, you need to have high risk tolerance and a longer time horizon to invest in sector-specific funds.