Sharekhan Blog

What are Sectoral Funds?

  • Mar 4, 2024

This article will cover the fine-tuning of specialised return accelerants, balancing risk-reward payoffs smartly.

What is a Sectoral fund?

Sectoral funds meaning are equity schemes investing in a specific sector of the economy, such as utilities, energy, infrastructure, etc. They allow investors to participate in the best-performing stocks in that sector.

Features of Sector Funds

Sector funds have certain key features:

  1. Expensive: They tend to be more costly than diversified funds since expenses are spread over a smaller asset base.


  1. Higher Risk: Relying on a single sector increases risk as other sectors have no cushioning effect.


  1. Higher Returns Potential: Investing in a consistently growing sector can give high returns over time.


  1. Divergent Performance: Different sectors perform differently depending on economic cycles.


  1. Limited Diversification: Investments concentrated in a single sector limit diversification.

Types of Sector Funds

Some common sector fund categories are:

  1. Real Estate Funds: Allow small investors to participate in the real estate market.


  1. Utility Funds: Invest in utility companies focused on providing steady dividends.


  1. Natural Resources Funds: Invest in oil, gas, energy, and related sectors.


  1. Technology Funds: Offer exposure to the high-growth technology sector.


  1. Financial Funds: Invest in banking, insurance, and accounting firms.


  1. Communications Funds: Focus on telecom and internet-based companies.


  1. Healthcare Funds: Invest in pharmaceutical, healthcare, and medical institutions.


  1. Precious Metals Funds: Offer exposure to gold, silver, platinum, and other metals.

Working of Sector Funds

Sector funds invest in companies operating in the designated sector subset. Particular sectors may offer strong growth potential. However, concentrating on a single sector significantly increases volatility.

Sector funds provide some diversification through multiple holdings. However, the entire portfolio remains vulnerable to factors affecting that industry. When the sector underperforms, so does the scheme.

Investment Approach for Sector Funds

Sector funds carry higher risks given concentration in specific industries. However, for investors willing to embrace increased volatility, these funds offer exposure to potentially fast-growing economic segments. One can invest in sector funds through Systematic Investment Plans, lump sum purchases during market declines, or even transfers from existing diversified funds based on risk appetite. Choosing the right investment vehicle and entry timing calls for research and discipline.

How to Choose the Right Sectoral Fund?

Selecting an appropriate sector fund suited to one's investment needs and risk appetite requires evaluating multiple aspects. Investors must assess their financial goals and timeframes and analyse sector trends before deciding.

Key factors to consider are:

Investment Horizon: Sector funds carry higher risks given their concentrated sector bets. Hence, these suit investors with longer-term investment horizons, allowing sufficient time for temporary downturns to average out.

Risk Appetite: Sector funds tend to be more volatile than diversified funds. One must gauge risk tolerance levels and the ability to withstand periods of large value fluctuations.

Sector Analysis: Research the outlook on the target sector with respect to the competitive landscape, growth trends, business cycles, regulatory changes, etc., to determine its investment merit.

Economic Environment: Analyse the broader economic health and factors like inflation, interest rates, consumer demand, etc., that could indirectly impact the attractiveness of a sector.

Fund Selection: Compare relevant sector funds on parameters like past returns, expense ratios, fund manager credentials, etc., to shortlist appropriate schemes. Prefer funds with long track records.

Review and Rebalance: Monitor sector performance at regular intervals. Realign fund allocation if risk profile worsens or investment objectives change.

Taxation of Sector Fund Returns

Sector fund returns are taxed like other equity funds. So short-term capital gains under 1 year attract 15% tax while long-term gains over 1 year attract 10% tax.

Sectoral Mutual Funds vs Diversified Funds

Sectoral mutual funds invest in a specific industry sector, while diversified funds spread investments across sectors. This difference highlights the tradeoff between higher potential returns and increased risk.

Sectoral mutual funds can generate higher returns if the particular sector performs very well over time. The concentrated sector bets make the most of a booming industry's growth. However, just as returns can be amplified in an uptrend, performance can worsen significantly if the cycle turns unfavourable.

In contrast, diversified funds allocate investments across industries and sectors. This cautions against overexposure to any single sector, limiting the highest profit potential. At the same time, diversification provides a cushion against industry-specific downturns. When some sectors face difficulties, other thriving sectors balance the overall performance.

Conclusion

Sectoral funds offer the prospect of capitalising on high-growth industry trends. Concentrated bets assist in participating fully in a secular bull run. However, a lack of diversification also increases volatility and downside risks. Investors should thoroughly assess their risk appetite, research sector outlooks, and align decisions with long-term financial goals before opting for sector funds over diversified alternatives. Moderation and patience are key while investing in these specialised instruments.

Team Sharekhan
by Team Sharekhan

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