Mutual funds are a well-liked investment choice for many individuals. They provide a diversified portfolio of stocks and bonds, which helps to reduce risk. Sectoral mutual funds are a type of mutual fund that has gained popularity in recent years. In this article, we will discuss what sectoral mutual funds are, how they work, and their advantages.
What are sectoral mutual funds?
A sectoral mutual fund is a type of equity fund that invests in businesses that belong to the same industry or sector. By putting their money in companies of the same sector, investors can get exposure to specific sectors of the economy.
For instance, the economy of India consists of many sectors, such as technology, banking, pharma, natural resources, and so on. Some of these sectors may perform very well in the medium to long term, and turn a healthy profit. As an investor, you can capitalise on opportunities arising from growth in your chosen sectors, with the help of sectoral mutual funds.
How do sectoral funds work?
Every equity mutual fund invests the money collected from investors in stocks of companies. The only difference with a sectoral fund is that it invests all its money in stocks of companies that belong to the same sector. A sector is defined as a group of similar businesses that provide the same category of products or services.
For instance, the technology sector consists of companies that provide technology-related products or services. Similarly, a pharma sectoral fund will invest in companies that provide pharmaceutical-related products or services. As an example of how diverse sectoral funds can be, it is not necessary that the pharma sectoral fund will invest in companies that only manufacture medicine. It has a host of other options that it can invest in like hospitals, diagnostics, etc.
Furthermore, sectoral funds invest in companies of all sizes from large-cap to mid-cap to small-cap; but the only mandate is that they should belong to the same sector. As per the norms set by SEBI (Securities and Exchange Board of India), all fund managers who take care of sectoral funds need to invest at least 80% of the fund’s total assets in equity and equity-related instruments of a particular sector.
Types of Sector Mutual Funds in India
- Technology Funds: These mutual funds concentrate on electronics and IT companies, offering investors exposure to the dynamic technology sector.
- Financial Funds: Enabling investment in financial industry stocks, this category covers banks, insurance companies, investment firms, and accounting entities, providing a broad spectrum within the financial domain.
- Natural Resources Funds: Focused on energy, forestry, oil, natural gas, and timber-related industries, these funds suit investors seeking long-term growth opportunities in resource-based sectors.
- Precious Metal Funds: Catering to those interested in precious metals like gold, silver, platinum, and palladium, these funds offer a channel for capitalising on the potential gains in the precious metals market.
- Real Estate: Providing an avenue for small investors to engage in real estate, these funds offer income and growth benefits within the real estate market.
- Communication Funds: Primarily investing in the telecommunication sector and other internet-related companies, these funds align with the ever-evolving communication industry.
- Utility Funds: Geared towards providing steady dividends, utility funds invest in companies within the utility sector, offering stability and income.
- Healthcare Funds: Investing in pharmaceutical companies, for-profit healthcare institutions, lab chains, and biotechnology firms, these funds also support companies involved in groundbreaking research within the healthcare industry.
- FMCG Funds: Sector funds in the fast-moving consumer goods (FMCG) industry, investing in companies producing essential everyday items, reflecting stability and consistent demand.
Advantages of sectoral mutual funds
- Potentially high returns: Sectoral funds provide several benefits to investors. First, and most importantly, they may have the potential to earn you high returns. However, for that to happen, the sector you choose to invest in needs to perform well.
The nature of sectors is cyclical; hence, any sector you choose will have good cycles and bad ones. Research and analyse your desired sectors carefully, and observe them over a period of time, so that you invest in the correct cycle to have a chance of making exponential returns.
To give you an example of this, people who chose to invest in pharma sectoral funds earned returns of over 27% when the outset of Covid happened.
Thus, if you choose the right sector and the right timing, you could earn better returns than normal.
- Targeted exposure: By investing your money in a specific sector, you get increasingly exposed to the market performance of that industry. If you have sufficient knowledge or expertise to judge the performance of this sector fairly over time, you may benefit from knowing just when to buy stocks, and when to sell.
- Diversification: If you want to have a diverse portfolio, but do not wish to spread your investments out over multiple industries, sectoral mutual funds are a great option for you. They help diversify your investments within a particular industry or market segment. This way, even if one or two companies in your portfolio do not earn high returns, the others will likely perform well and thus mitigate any loss.
Risks involved while investing in Sectoral Mutual Funds
- Cyclical Nature: Sectoral funds are susceptible to cyclical trends within a specific industry, making them vulnerable to economic ups and downs related to that sector.
- Limited Diversification: These funds focus on a particular industry, resulting in limited diversification across various sectors. This lack of diversification can amplify losses in the event of economic changes affecting that industry.
Who Should Invest in Sectoral Funds?
- Aggressive Investors: Sector funds, being among the riskiest mutual funds, suit individuals comfortable with embracing high levels of risk in their investment portfolios. These funds cater specifically to venturesome investors seeking potentially high returns.
- Informed Investors: Delving into sector funds necessitates a nuanced understanding of market trends and effective timing for entry and exit. Even seasoned investors may find this challenging. Staying abreast of sector-related news and conducting thorough research is crucial for making informed investment decisions in this domain.
- Tactically Oriented Investors: Investors equipped with substantial knowledge about a particular sector, coupled with a robust risk appetite, can strategically capitalise on the cyclical nature of sector funds. Strategic entry during a sector's downturn and timely exit during its upswing can be advantageous for investors with tactical allocation preferences.
Taxation of Sector-based Funds
Investors venturing into the realm of the best sectoral mutual funds should be well-versed in the associated tax considerations.
Long-Term Capital Gains (LTCG): For investors holding units in a sector fund for a period exceeding one year, they accrue long-term capital gains. The first Rs. 1 lakh of such gains remains tax-free within a financial year. Any returns surpassing this threshold incur a 10% tax, without the benefit of indexation.
Short-Term Capital Gains: Contrarily, if an investor holds units for less than one year, the resulting gains are categorized as short-term capital gains. A 15% tax rate is levied on such gains, emphasizing the importance of considering the holding duration for tax optimization.
Factors to Consider before Investing in Sector Funds
When contemplating investments in sectoral funds, it is crucial to evaluate several factors for informed decision-making.
- Align with Investment Goals: Before delving into sector funds, align your investment objectives with long-term financial goals, such as education funding or building a retirement corpus. A recommended investment horizon of 5 to 10 years is advisable to navigate the potential risks associated with these equity funds.
- Gauge Risk Appetite: Sectoral funds represent concentrated investments, necessitating a high-risk appetite from investors. Be prepared for the elevated risk inherent in these mutual fund schemes.
- Diversify Your Portfolio: To mitigate risks associated with sector funds, it is prudent to maintain a diversified portfolio with other mutual funds. Limiting exposure to sectoral funds is advisable due to their inherently high risk.
- Understand the Expenses: Consider the expense ratio charged by Asset Management Companies (AMCs) to cover administrative and operating costs. Sector funds often entail higher sales charges and annual expenses, making it imperative to assess the expense ratio's impact on overall returns.
In conclusion, Investors seeking high-risk opportunities may choose sectoral funds. These funds concentrate on a specific sector, and their limited diversification makes them among the riskiest mutual funds. Therefore, only the investors comfortable with high-risk scenarios should contemplate investing in them.
Hence, make sure to thoroughly research the industry before putting your money into any specific sectoral fund.
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