Sector funds have a sex appeal to it that a regular equity diversified option can never have. They allow you to venture off the straight and narrow path. Unfortunately, the rocky road is too much for most. And the hair raising volatility makes it difficult for investors to stick on for the ride.
Sector funds concentrate their investments in a single sector, such as FMCG, financial services, healthcare, and technology. Investors allow for them to make an appearance in their portfolio because they allow for the possibility of extraordinary returns. There is nothing inherently wrong with such a fund. It is the investors’ mentality that leads to defeat. They know that such funds have the potential of great advances. But they also choose to ignore the deeper decline in value that comes with the turf.
An issue with sector funds is that investors rarely act on a well thought out strategy. They simply gravitate towards the flavour of the year, which means that they are already behind. A financial planner noted that people who invest in today’s winners are “buying backward”.
For instance, energy funds (Morningstar category: Sector – Energy), put up a stellar performance in 2007 with a return of 105% that year. Investors piled onto funds in the sector. The next year the category average was -53%. No doubt, the mayhem that year hit every single sector. While it bounced back the next year, its returns in 2010, 2011 and 2013 were abysmal. In 2014, it made a comeback with a return of 47%, but still a far cry from its 2007 feat.
Or, take a look at financial services (Morningstar category: Sector – Financial Services). For three years it kept sliding: 76% (2009) to 29% (2010) and -33% (2011). It picked up in 2012 to deliver a category average of 56% but once again dipped in 2013 to again pick up in 2014.
An essential characteristic of sector funds is that they can shoot out the lights one year and be a loser the next because they essentially lack the diversification to ride out trouble. One should never commit the grave error of investing in a sector fund simply because it has had a great run that year. Unlike a regular equity diversified fund, the fund manager does not have much latitude if the sector falls from favour.
Could you do without them entirely?
John Bogle, the founder of Vanguard funds, believes you can. He is known to have said: "You could go your entire life without ever owning a sector fund and probably never miss it." Bogle's point is simply that a well-diversified portfolio doesn't need sector funds because that particular sector would already be well represented in a few diversified equity funds.
By and large, buy-and-hold investors should steer clear of sector funds altogether, because not only are they betting on a single sector, but they are betting heavily on a few companies.
On the other hand, sector funds can be useful tools for investors with strong views who want to give a tactical slant to their portfolio. In areas of the market you are confident about or see an upturn in the future, you can employ a sector strategy to increase exposure. But if you invest in them, you need to understand exactly what you’re buying — and how much risk is involved.
Before you invest in a sector fund, you should be in a position to articulate your stance on why you believe that sector is likely to outperform, and what your criteria are for exiting it.
Ask yourself three questions: 1) Why do I believe that that particular sector is likely to outperform, 2) What is the time frame I am looking at, and 3) What is my criteria to offload. If you can't answer these questions, you probably shouldn't own it.
It’s always tempting to jump into sectors when they are hot. And sector funds will be able to deliver some stupendous returns on and off, giving your portfolio the muscle to outperform the market. Yet don’t lose sight of the fact that they can also log some dizzy falls. Instead, decide on your sector allocation based on your risk capacity, not on how well that particular sector is doing.
Finally, when you invest in a sector funds, you should be geared to take a hit. After all, you may get your call wrong. Alternatively, when the relevant sector is on a roll, don’t be afraid to leave potential gains on the table. Staying on in the hope that the sector will keep sizzling could backfire. And, as long as you are invested, don’t let hair-raising volatility disturb you or prevent you from sticking to your investment strategy.
Follow these three guidelines when investing in sector funds:
- Sector funds must never be a core holding, instead, they should corner a very small portion of your portfolio. And when you do decide to allocate a portfolio of your portfolio to such a fund, ensure that you do so with a strategy in mind.
- If you have earned substantially well, walk away. Don’t get upset about leaving potential gains on the table. You took a call and you made money – don’t let greed mess it up.
- Volatility is a given; don’t let it shake you. Have a clear investment strategy as to why you want to invest in that sector and stick to it. If you find your call was wrong, then you can decide whether to pull the cards off the table or just hold on. But whatever you decide, it will be an informed decision. And that is how investments must be made.
