Diversified funds versus sector funds – How to make the choice

It is significant to understand the basic difference between the diversified funds and sector funds before making any comparison of the two. Diversified funds are mainly large-cap funds across themes and sectors. These are one of the best large cap mutual funds that you can invest in. While the sector funds are focused on a specific industry group or sector.

A few examples of sector funds are the IT Fund, Banking Fund, FMCG Fund, and Pharma Fund. You need to ask some basic questions before choosing any type of fund. You cannot enjoy the benefits of diversification by investing in direct equities. Therefore, a mutual fund is the best way to get these benefits. Investing in sector funds offers a concentrated risk that goes against the core of diversification.

So, the main question is, “Should you invest in a sector or diversified mutual funds and what drives you to make that choice?”

Main aspects to remember before choosing

Let us have a look at the 5 major factors that need to be considered before making a choice: 

You must consider the risks and long-term cycles when looking at sector funds-

You must look at all the dimensions of a sector fund. For instance, a steel fund will perform well during the steel cycle’s upside time while it may get affected grossly after that. Similarly, when the rates of banking funds rise, they may perform well and then underperform when it falls down. Any profit made by luck cannot become an investment strategy. Therefore, you must determine all the dimensions to get a much clearer answer. So the rule is to opt for diversified equity funds for the creation of wealth and to only rely on sector mutual funds for a short period.

How you can diversify risks with sector mutual funds-

The answer is that it is not possible to diversify risks with sector mutual funds. You need to go against the basics of investment strategy in mutual funds. You should ask yourself, why are we investing in mutual funds? It is because mutual funds give us expert fund management, diversification and a stress-free mind. This allows you to expand your risks across sector cycles and themes. You rely on a fund manager as you lack the ability and the money/capital to manage things yourself. By choosing a sector fund, you compromise on the benefits of diversification. This is because your portfolio solely hinges on the performance of one specific sector/industry.  

How can we benchmark the sector funds’ performance-

Finding the benchmark of the performance made by the sector funds is one of the biggest challenges. You can check the benchmark of your diversified funds against Nifty and Sensex. But its reading becomes complicated because of the lack of representative indices. When you invest in mutual funds, you can determine whether the index is overvalued or undervalued in relation to its history of trade. It is difficult to get reliable benchmarks for sector indices.

You concentrate your portfolio performance on one sector-

One of the main questions you need to ask is- do you want to hand the fate of your long-term goals to one sector? Frankly speaking, it is not a great idea. You should not rely on the performance of 1 or 2 specific sectors to handle the fate of your child’s education and retirement plans. It can be a short-term solution for a short-term trend. In India, the IT sector funds have been extremely unstable in several cycles, while the pharma sector is dependent on the FDA of the US. This is the main disadvantage of sectoral portfolios. 

The sector funds must be treated as alpha hunters-

The answer is to not abandon sector funds altogether. You must consult with your financial advisor and get exposure to your equity portfolio’s 10-155 in-sector funds. You must maintain discipline and ensure the proper execution of an exit plan. By having a clear-cut exit plan, you make an alpha move through concentration risk that does not affect your overall portfolio. Even in the worst situation, you can rely on your balance of 85% of your equity portfolio. 

The Core Take-Away

Thus, after discussing the various factors of the two funds, we come to the conclusion that sectoral funds are not as good as diversified equity funds. To make a better and more informed decision on the type of investment, you must get a small exposure to the sector funds. So, people looking for the best large cap mutual funds must choose to invest in diversified equity funds.  In short, some sector fund investment industries require more due diligence. The risks involved in investing in a particular sector affect the whole investment portfolio. Investing in sectoral funds needs to be done in high-growth potential industries to minimize loss and fluctuations. This type of investment takes time and talent and the results are completely unpredictable. An individual looking for the right place to invest must determine the long-term prospects and the fundamentals of the company. 

Related Posts