Sectoral mutual funds: Advantages and how to invest

Posted On: 17 April 2024

Sectoral funds are types of mutual funds that invest in specific sectors of the economy, such as technology, healthcare, banking etc. Understanding the meaning of equity sectoral funds is crucial for investors looking to diversify their portfolios.  

Let’s take a closer look at all you need to know about sectoral funds.

Table of contents

What is a sector mutual fund?
How does a sector mutual fund Work?
Features of sectoral funds
Types of sectoral funds
What to consider before investing in sectoral funds?
Taxation of sectoral mutual funds
Who should invest in sectoral funds
Opportunities associated with sector-specific mutual fund investments
Risks associated with sector-specific mutual fund investments
How to invest in sectoral mutual funds

What is a sectoral mutual fund?

Sector mutual funds, sometimes also referred to as sectoral funds or sectoral mutual funds, are mutual funds that invest solely in businesses in a particular sector of the economy. As per SEBI regulations, a mutual fund scheme can be called a sectoral mutual fund if it invests 80% or more of its total assets in equity and equity-related instruments of a particular sector. There is no restriction on the company size with respect to its market capitalisation.

Sector mutual funds, by definition, offer less diversification than other types of mutual funds since the investment is predominantly in one sector of the economy. However, they allow investors to take advantage of growth in a particular industry segment.

How does a sectoral mutual fund work?

As explained, sector funds invest in a particular sector such as technology, healthcare, energy, or financial services. Fund managers analyze and select companies within the chosen sector that they believe hold growth potential. They assess industry trends, market dynamics, and company fundamentals to make investment decisions.
The portfolio consists of stocks from companies within the targeted sector. Depending on the investment strategy, it may include a mix of large-cap, mid-cap, and small-cap firms. The fund manager continuously monitors and adjusts the portfolio, buying or selling stocks based on sector performance and company outlook. The objective is to leverage sector growth trends and generate returns for investors.
These funds carry higher risk than diversified equity funds due to their sector-specific focus and concentrated approach.

Features of sectoral funds

Investment strategy: Sectoral funds focus on companies of a particular sector that are expected to outperform the broader market. Investment managers carefully select companies within a specific sector, aiming to optimise the return potential. This approach requires in-depth knowledge of the sector’s trends and challenges.

Risk and return: The risk and return profile of sectoral funds can be higher than that of diversified mutual funds. Because these funds invest in a specific sector, they are more sensitive to fluctuations within that sector and hence associated with some concentration risk. However, with higher risk comes the potential for higher returns, especially if the chosen sector performs well.

Types of sectoral funds

There are several types of sectoral funds, each focusing on a different part of the economy. Some examples include:

Technology funds: Invest in information technology companies, including software, hardware, and internet services. This sector is known for its high growth potential, driven by innovation and the increasing reliance on technology in all aspects of life.
Healthcare funds: Focus on pharmaceuticals, hospitals, and healthcare services. The healthcare sector can offer a relatively stable return potential due to the constant demand for medical services and products.
Financial services funds: Target banks, insurance companies, and financial institutions. This sector can benefit from overall economic growth and increased financial transactions.
Consumer goods funds: Invest in companies that produce goods used by consumers, such as food, beverages, and personal products. These funds can be resilient during economic downturns as they invest in companies providing essential goods.

What to consider before investing in sectoral funds?

Before investing in sectoral funds, investors must evaluate several key factors to ensure that their investment decision align with their financial goals and risk tolerance.

Understanding the sector: Investors should have a clear understanding of the sector they plan to invest in. This includes knowledge of the sector's growth drivers, potential risks, and the impact of economic cycles on its performance. A sector that seems promising today may face challenges tomorrow, so staying informed is key.
Investment horizon: Sectoral funds often require a longer investment horizon due to their inherently volatile nature. Investors should be prepared to hold their investments through periods of fluctuation to realise potential gains. Short-term investors might find the volatility of sectoral funds challenging to manage.
Risk assessment: Given the concentrated nature of sectoral funds, they are relatively riskier than diversified mutual funds. It’s important for investors to assess their risk tolerance and consider how comfortable they are with potential downturns in a specific sector.
Portfolio balance: Investors should consider how a sectoral fund fits into their overall portfolio. While sectoral funds can offer a high return potential, they should complement a diversified investment strategy to mitigate risk. Balancing sectoral funds with investments in other asset classes can potentially mitigate the effect of against sector-specific downturns.
Fund management: The expertise of the fund management team is crucial in sectoral investing. A skilled portfolio manager can make informed investment decisions with regard to the sector and adapt to changing market conditions.
Expense ratio: These funds may have higher expense ratios due to the specialised research and active management required. It’s important for investors to consider these costs when choosing to invest in sectoral funds.

Taxation of sectoral mutual funds

Sectoral mutual funds, like other equity-oriented mutual funds, are subject to capital gains tax in India, based on the holding period of the investment. Here’s a summary of how taxation applies:

Short-term capital gains (STCG): Selling units within 12 months results in short-term capital gains. STCG is taxed at 20%.

Long-term capital gains (LTCG): Selling units after 12 months results in long-term capital gains. LTCG is taxed at 12.5%, but the first Rs 1.25 lakh of LTCG in a financial year is tax-exempt.

Who should invest in sectoral funds?

Sectoral funds can be suitable for investors who:

Have a high risk tolerance
Have a clear understanding of the sector that they are investing in
Are looking to complement a diversified portfolio with targeted investments in high-growth sectors

Opportunities associated with sector-specific mutual fund investments

Sector mutual fund investments can provide a suitable way to diversify your portfolio by offering exposure to specific sectors. Instead of directly investing in individual stocks, these funds enable diversified sector investments, capturing anticipated growth potential.

Additionally, sector funds can act as a hedge for your portfolio. For instance, during a sudden rise in energy prices, while other industries may suffer, the energy sector can thrive. Investing in a sector fund focused on energy companies can, therefore, serve as a hedge.

The following are some of the key sector mutual fund opportunities:

Enhanced growth potential: When a chosen sector experiences a surge, sector-specific funds can outperform the broader market due to their concentrated exposure.

Specialised expertise: These funds are managed by teams with in-depth knowledge of specific sectors, potentially leading to informed investment decisions.

Hedging portfolio risk: Strategically investing in uncorrelated sectors can balance your portfolio, mitigating overall risk during market downturns.

Targeted investments: If you have strong conviction in a particular sector's future, these funds offer a direct way to capitalise on its potential.

Risks associated with sector-specific mutual fund investments

Looking at the flipside of the coin, here are some of the sector mutual fund risks:

Volatility: Sector-specific funds are inherently more volatile than diversified funds. A single sector's downturn can significantly impact your investment value.

Putting all your eggs in one basket increases the risk of substantial potential losses if the chosen sector falters.

Limited diversification: Lack of diversification exposes you to the specific risks and challenges of the chosen sector, reducing overall portfolio stability.

Timing the market: Predicting which sector will boom next is challenging, and making the wrong choice can lead to significant losses.

How to invest in sectoral mutual funds

Investing in sectoral mutual funds requires thorough research due to their focused nature. Here's a step-by-step guide:

Research and choose a sector: Study economic trends, government policies, and industry growth potential to identify a suitable investment avenue.

Select a sectoral fund: Evaluate sectoral funds based on performance*, expense ratio, and fund manager expertise. Understand investment objectives, risk factors, and portfolio details. *Past performance may or may not be sustained in the future.

Choose an investment platform: You can invest directly with the Asset Management Company or through a mutual fund distributor. You can also invest through an aggregator platform.

Make the investment: Submit necessary details and choose between lumpsum or Systematic Investment Plan (SIP).

Conclusion

Sectoral funds offer a unique investment opportunity, allowing investors to capitalise on the growth of specific sectors. Understanding the equity sectoral thematic meaning is key to making informed decisions about these types of investments. While they carry higher risk due to their lack of diversification across sectors, they also offer the potential for higher returns. Investors should carefully consider their risk tolerance, investment goals, and costs before diving into sectoral funds. With the right approach, sectoral funds can be a suitable addition to a well-rounded investment portfolio.

FAQs:

What are sectoral funds?

Sectoral funds are mutual funds that invest in specific sectors of the economy, aiming for a higher return potential by capitalising on sector growth.

Who should consider investing in sectoral funds?

They are ideal for investors with high risk tolerance and interest in specific sectors, offering a way to diversify portfolios through targeted investments.

What should I consider before investing in a sectoral fund?

Important considerations include understanding the sector, assessing risk tolerance, evaluating the fund's management, and ensuring the investment complements your overall portfolio.

Is it safe to invest in sectoral mutual funds?

No, sectoral mutual funds are usually categorised as very high risk. They can be riskier than more diversified equity funds because they concentrate on a specific industry and depend heavily on that sector’s performance. They may be suitable for experienced investors with a long investment horizon, a high risk appetite and a deep understanding of the sector’s trends.

Are thematic mutual funds the same as sectoral funds?

No, thematic mutual funds invest in broader themes (such as technology, consumption, ESG, healthcare etc) that may span multiple sectors, while sectoral funds focus on a single industry.

What are the disadvantages of sectoral funds?

Sectoral funds are riskier due to their concentrated exposure. They require active monitoring and expertise, as poor performance in the chosen sector can significantly impact returns.

What is the cyclical nature of sector funds, and why is it important?

Many sectors are cyclical, meaning that they offer growth in certain conditions and declines during others. In other words, they are significantly impacted by business cycles. It is important to know if a sectoral fund invests in a cyclical sector or a defensive one, so that investors are better prepared for the risks involved.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.