Some 51% of sector funds underperform their benchmarks. Some that perform well, may have invested in stocks outside the sector

Moneylife Digital Team

Sector funds usually focus their attention on stocks in a particular sector. Sector funds tend to be riskier and more volatile than the broad market because they are less diversified, although the risk level depends on the specific sector. Some investors choose sector funds when they believe that a specific sector will outperform the overall market, while others choose sector funds to hedge against other holdings in a portfolio. Some popular sector funds focus on financial services, gold and precious metals, healthcare and infrastructure. Such concentrated portfolios can produce tremendous gains or losses, depending on whether the chosen sector is in or out of favor.

There are a total 49 sector funds, out of which 51% (25) have underperformed their respective benchmarks, while 22 funds have outperformed and two have managed to equate the benchmarks. The underperformers just managed an average return of 4% since inception as compared to their respective benchmarks which gave an average 11%. The outperformers gave an average return of 18% since inception as compared to their benchmarks which gave an average return of 12%.

Among the outperformers, the top 5 are Sahara Banking and Financial Services Fund with a return of 54%, Franklin Infotech Fund that fetched 16%, Birla Sun Life Basic Industries with 22% returns, Reliance Pharma Fund-with a return of 27%, and Birla Sun Life MNC with 19% returns.  The worst five performers since inception were Reliance Infrastructure Fund-Ret (-8%), UTI Energy Fund (0%), Baroda Pioneer Infrastructure Fund (-15%), Bharti AXA Focused Infrastructure Fund (-13%), and JM Financial Services Sector Fund (0%).

Interestingly, when you buy a sector, you may not get an exposure to that sector! Some enterprising fund managers have tried to overcome the handicap of a sector by investing in stocks that have little to do with the concerned sector, or combining unrelated sectors to boost their chances. There are several instances where funds have stretched their investment mandate beyond recognition-infrastructure funds investing in pharmaceuticals, media-focused funds investing in airlines and retail, so on and so forth. Moreover, it is pertinent to note that the top diversified equity funds tend to beat their sector counterparts quite handsomely. As such, it is best to avoid sector funds, unless one wants to try a concentrated bet.

So, have the outperformers earned those returns by investing in their respective sectors, or have they gone out of their way to fetch returns? The answer is yes, they have gone out of their way to earn those returns. Let's look at the portfolios of a couple of these outperformers.

Franklin Infotech Fund launched on 3 September 1998 with an objective to provide long-term capital appreciation by investing primarily in the information technology industry, having BSE IT as the benchmark. The fund gave a return of 16% since inception. The funds portfolio as on February 2011  include stocks like Indraprastha Gas Ltd, Coromandel International Ltd, Torrent Power Ltd, Jet Airways India Ltd, Andhra Bank, Mundra Port & Special Economic Zone Ltd and Petronet LNG Ltd, which are in no way related to the information technology industry. So what are these stocks doing here?

ICICI Prudential Infrastructure Fund has an objective to generate capital appreciation and income distribution to unit holders by investing predominantly in equity/equity-related securities of the companies belonging to the infrastructure industries. But by looking at its portfolio it does not seem to fulfill its investment objective. Its portfolio as on February 2011 consists of a majority of banking stocks such as ICICI Bank, Standard Chartered PLC, HDFC Bank, Corporation Bank, State Bank of India, and other stocks like Great Eastern Shipping, CESC, Oberoi Realty, and so on. The fund gave a return of 11% as compared to its benchmark of 8% since inception.

Thus, the outperformers of the sector funds are not following their sectors as they are commonly understood. That makes them equity diversified funds, not sector funds.

There is a reason why funds do it. If they stick to their mandate, they may not perform well. As we pointed out in our article in the Moneylife edition of 2 December 2010: "The right sector fund can work wonders if one makes a correct call, especially since such funds make concentrated bets. If the sector does perform well, the earnings are phenomenal. Therein lies the catch-accurately picking a winning sector, just in time, is easier said than done. It is known only with hindsight. So, a fund focused on a specific sector is launched well after a sector has witnessed a hot streak over a long duration. Unfortunately, by the time the sector is identified and the fund is launched, it may have already run its course substantially."

 Disclaimer: All our mutual fund analysis is based on the data purchased from Mutual Funds India database, controlled by rating agency Moody's of US. While the analysis is our own we cannot guarantee the that Mutual Funds India has reported the data correctly.