What should you know before investing in sectoral mutual funds?

Investment is all about diversification, but sometimes it is also about concentration. If it were not, why were so many sectoral or thematic mutual funds available to investors? However, before you invest in sectoral mutual funds, you need to understand them. Also, you need to know the risks associated with them. They are like other mutual funds only, but here, the focus is on a particular sector or industry - potential for higher risk but also higher risk. There is no exception to the risk-reward equation. Let us get started with sectoral mutual funds.

What are sectoral mutual funds?

Sectoral mutual funds are a type of equity mutual fund that invests primarily in the stocks of companies operating in a specific sector or industry. Unlike diversified equity funds that spread their investments across various sectors, sectoral funds concentrate their portfolio in a particular market segment.

Some common examples of sectoral mutual funds include technology, healthcare, energy, financial services, and consumer goods. 

How Do Sectoral Mutual Funds Work?

Let us now look at how sectoral mutual funds work. Sectoral mutual funds, like any other mutual fund, work by pooling money from multiple investors and investing that capital in stocks of companies operating within the chosen sector or industry. The fund manager's goal is to capitalize on the growth potential of that specific sector. Here's how they work:

Sector Selection: The AMC selects a specific sector or industry to focus on based on their analysis and market trends. For example, post-pandemic (2020), we have seen many sectoral mutual funds in the healthcare sector. AMC launches sectoral mutual funds because the chosen sector could be experiencing growth or have potential for future growth.

Stock Selection: Once the sector is chosen, a fund manager is assigned. She selects individual stocks of companies within that sector to include in the portfolio. The selection process is usually based on the company's financial health, growth prospects, and valuation.

Portfolio Diversification: While sectoral funds concentrate on a particular sector, they still aim for some level of diversification within that sector to spread risk. It can involve holding stocks of companies with different market capitalizations and business models. For example, in healthcare sectoral funds, diversification can be achieved by selecting companies from the pharma segment and some companies that run hospital chains.

Factors to consider before investing in sectoral mutual funds

Here are the top 5 points to consider before investing in sectoral mutual funds:

• Risk: Sectoral funds are inherently riskier than diversified equity funds because they are exposed to the performance of a single sector. If the chosen sector experiences a downturn, it can significantly impact the fund's returns. For example, if you have invested in a technology sector fund, the chances are your fund is underperforming in 2023. The reason is simple: recession fear and economic slowdown. The fund manager has no option to optimize returns for you.
• Research: You must thoroughly research the sector you plan to invest in. Understand its current status, growth prospects, and any potential risks or challenges it may face in the future. Your investment decisions should be backed by solid data points. Don't invest because your friends are investing or someone is selling the fund to you.
• Diversification: While sectoral funds focus on a specific sector, it is still essential to ensure that the fund provides some level of diversification within that sector. A well-diversified portfolio can help mitigate risks. For example, with a technology fund, if a particular fund has some AI-based companies with good exposure, it will help protect the downside of your portfolio in current times as AI companies and their products are in demand (example only for understanding).
• Investment Horizon: Consider your investment horizon. Sectoral funds are more suitable for investors with a long-term perspective, as short-term fluctuations can be significant.
• Costs: Pay attention to the fund's expense ratio and other associated costs like you would for any other mutual fund. High fees can eat into your returns over time.

Should you invest in sectoral funds?

You can consider investing in sectoral funds if you satisfy the below criteria:

• You are comfortable taking a risk.
• You are a well-informed and active investor who is constantly updated on all the news and can draw conclusions from it.
• You are one of those who can make tactical allocations. For example, for a cyclic sector, you can make an entry when you believe the sector has hit the bottom, hoping to sell when the cycle turns upside down. 

Before you go

We have discussed things to consider before investing in sectoral mutual funds and who should invest in them. If you fall into the above categories, take advantage of sectoral mutual funds. However, as per experts, you should not give too much weight to sectoral mutual funds in your portfolio. Your exposure to sectoral mutual funds should be 5% to 10% of your total portfolio. We hope, after reading this article, you will be able to make the right decision.