Sector funds focus on the stocks of just one sector. While the logic of sector funds is attractive, buying them is a bad idea; for, fund managers have rarely proven to be smart at selecting the winning sectors. But if you must buy one, which ones should you look at and which are the ones to avoid? Moneylife Research Desk finds out

Moneylife Digital Team

The theoretical case for sector funds is strong. After all, the case can be based on two very strong tenets of investing: one, focus and concentration on a few stocks works wonders; two, identifying the right sector is an important component of stock market success. Sector funds incorporate both these aspects of investing. They focus on just one sector at a time and, if the sector does well, the fund’s performance can be among the best.

Well, this is all theoretical. Firstly, fund managers have rarely proven to be smart at selecting the winning sectors. They were caught unawares by the tech bust of 2000 and also the construction boom (albeit with current unsold inventories) since 2004.

That is why we believe that while the theoretical logic of sector funds is attractive, in practice, it is best to avoid them. The concentration argument cuts both ways. They are launched not when a sector is about to start a major rally but when it has already reached a peak. And, because such funds’ bets are concentrated on one sector, they carry a huge risk of underperformance. This is why they cannot beat the best of diversified equity funds or index funds. We had demonstrated this in a three-year analysis of sector funds in our 7 April 2006 issue (“Sector Funds? Bad Idea”).

Here is the updated evidence. Sector funds have earned an average return of 11% since their inception. And what if you had invested your money in equity diversified funds? The average return would have been 13% since inception. But if you are hell-bent on buying a sector fund, which ones should you look at and which are the ones to avoid?

The Best Sector Funds
There have been 43 sector funds with a history of three years or more. Of these, UTI Services Industries Fund and DSP BlackRock Natural Resources and New Energy Fund-Retail emerged as the best-performing sector funds with a three-year return of 20% and 13% since inception and they outperformed their respective benchmarks by 33% and 13%. Now service industry is hardly a sector and, no wonder, this UTI Services Industries Fund looks like a diversified fund.
Its top five stocks are ICICI Bank, Tata Consultancy Services, Infosys, Bharti Airtel and Axis Bank. DSP BlackRock Natural Resources and New Energy Fund has only one mid-cap stock; all others are large-cap stocks. The top five picks of this Fund are Castrol India, Reliance Industries, SRF Ltd, Hindustan Petroleum Corporation and Petronet LNG.

The problem is that there are few genuine sector funds. For instance, the database of Mutual Funds India puts Birla Sun Life Buy India as a sector fund. This makes no sense at all. This Fund claims to be focused on the consumer and healthcare sectors. But its investment is spread across dozens of sectors like auto ancillaries (Maruti), hotels (Taj GVK), banks (ING Vysya Bank), FMCG & food processing (ITC and United Spirits). This is really a diversified equity fund.

The remaining three (of the five best performing sector funds) are power, pharma and infrastructure funds. Reliance Diversified Power Sector Fund has given returns of 31% since inception. However, while the top picks of the Fund include Torrent Power, Cummins India and Jaiprakash Associates, it also has Jindal Steel & Power and ICICI Bank in its portfolio. Almost 27% of the Fund’s assets are invested in these five stocks.

Reliance Pharma Fund has earned a return of 28% since inception. Among its top picks are Divis Laboratories, Aventis Pharma, Sun Pharmaceutical, Cadila Healthcare and Ranbaxy Laboratories.

HDFC Infrastructure Fund has notched up a return of 4% since inception and has outperformed its benchmark S&P CNX 500 which is down by 6%. Well, it thinks ICICI Bank, Bank of Baroda, State Bank of India, Oil and Natural Gas Corporation are infrastructure companies—as also Motherson Sumi Systems, an auto-ancillaries company.

The Worst Sector Funds
In terms of risk-adjusted returns among equity schemes, infrastructure funds were among the worst performers. The worst three performers include Escorts Infrastructure Fund, L&T Infrastructure Fund and Kotak Indo World Infrastructure Fund. Even if you want to invest in sector funds, you must certainly avoid these worst performers for some more time. In fact, Escorts Infrastructure Fund tops the list of the worst-performing sector funds earning a pathetic return of -9% against its benchmark Nifty which earned a return of 4% for the same period. Its five top picks are McNally Bharat Engineering, Motherson Sumi Systems, Tata Motors, Voltas and Titagarh Wagons. Out of the top five stocks of this ‘infrastructure’ fund, two are from auto-ancillaries and one from consumer durables. L&T Infrastructure Fund has ended up with a return of -10% since inception, with stocks such as ICICI Bank, Reliance Industries, State Bank of India, Bharti Airtel and Larsen & Toubro in its portfolio. ICICI Bank, State Bank of India and L&T have grown significantly in the past three years; so what was the Fund doing? Timing the market? The Fund’s size is tiny with just Rs38 crore of assets as on 31 May 2011. The Fund was launched in September 2007, at the height of the bull market. The next worst-performing fund was Kotak Indo World Infrastructure Fund. The Fund has Rs324 crore in assets, of which 15% is invested in international mutual funds. Its top five stock picks are ICICI Bank, HDFC Bank, Bharti Airtel, Reliance Industries and L&T. The Fund earned a return of -10% since inception while its benchmark S&P Nifty earned 1% for the same period. The Fund was launched in January 2008, at the peak of the bull market. And if you see the returns of its top five stocks—except Reliance—all have done very well in the past three years. So what was the fund manager doing?



If funds from the same sector figure in the list of the top five as well as the bottom five performers, what does it indicate? Simply that fund managers do not know enough about the sector, the stocks and their possible price movements—even though such intense focus is the cornerstone of investing in sector funds. This is precisely why diversified equity funds usually do better than sector funds. They do so by depending less on the smartness of the fund managers and more on the performance of good companies. Sectoral schemes tend to move in cycles. And when a sector is hot, several new mutual funds are launched to cash in on the trend but you should stay away from them because that hot sector is invariably headed for a rough period. For example, the infrastructure sector was hot in 2006 and many infrastructure funds were launched. Their performance has been disastrous. If at all you want to invest in sector funds, choose funds that are long-term value creators. There are two such sectors: pharma and FMCG. Stocks in these two sectors have created great long-term value which is why sector funds focused on these two sectors have done exceptionally well. Keep an eye on them.

Fund benchmarks: Mutually opaque
Several funds are benchmarked to proprietary indices, making it impossible to measure their performance. SEBI remains unconcerned, so far

Mutual fund (MF) performance is not based on the returns that a fund earns but against an external standard called the benchmark index. MFs are supposed to be doing well, if they have beaten their benchmarks. MFs usually choose a popular benchmark like the BSE 500, the Nifty or the Sensex. The idea is that through a process of active stock selection, MFs would do better than their benchmarks.

But what if fund companies get so carried away with the way they create schemes that they end up selecting peculiar benchmarks? And what if the performance of these benchmarks cannot be tracked at all by retail investors? It makes a mockery of the very idea of benchmarks. We have tried to bring out the difficulties one faces while analysing the performance of sector funds:

•    We found that around seven sector funds (Read “Oddball”) are benchmarked to indices which are strange constructs.



•    The data for these benchmarks are not available in the public domain. Two funds, namely, Franklin Infotech and Birla Sun Life New Millennium (earlier Alliance New Millennium), were launched when the data of their respective benchmark indices—BSE IT and BSE TECk—were not available in the public domain.

•    Funds also use indices like the S&P CNX Media and Entertainment Index which are paid indices. The data for these indices are accessible only to subscribers. How is an ordinary investor supposed to check the performance of these funds against such benchmark indices?

•    Many of these sector funds are products of innovative ideas of fund companies. Sector funds come in all kinds of flavours (like UTI Transportation and Logistics Fund and UTI Energy Fund) whether they make sense or not. Such ‘innovative’ sector funds demand innovative benchmarks which are customised by the fund company.

•    The data for these customised indices are available only on the fund fact sheet and that too, only for periods that the fund company finds appropriate for comparing the scheme with its benchmark.
 
•    When a particular scheme’s name is changed, the launch date changes to the date on which the change takes place. UTI Energy Fund was earlier known as UTI Petro Fund and the launch date was July 1999. In November 2007, its name changed to UTI Energy Fund and so the launch date changed to November 2007 which is not reasonable at all for analysing returns.

•    Funds which have been taken over by other fund houses also suffer from the same date change. Apple Goldshare was launched in April 1994. In November 1998, this was taken over by Birla Sun Life and the name was changed to Birla Sun Life MNC Fund–Growth, and its launch date was also changed to November 1998. So, when you look for ‘since inception’ data, be aware of these problems.