We have not discussed much about sector funds in this column so far. For one, such funds carry concentration risk. For another, investors need to have a view on a sector before buying such funds. Given these factors, it was somewhat surprising when several readers wanted if such funds are attractive investments.
This article shows how investors can create a portfolio using sector funds. It uses a naive asset allocation process to make it more meaningful for individual investors. Sophisticated asset allocation process can improve such portfolio`s risk-adjusted returns.
It should not be surprising if mass-affluent investors find sector funds risky. Take Franklin FMCG Fund. It had more than 10% exposure in its top three holdings as on August 2010. But that is not as concentrated as ICICI Prudential Technology Fund, which had about 75% of the total exposure in just two stocks during the same period!
The point is that sector funds carry high concentration risk. Such funds are typically meant for investors who have a view that a certain sector is likely to outperform broad-cap index in the future. An investor, for instance, would have generated about 50% if she had invested in the FMCG sector last year.
Choosing the right sector is, of course, not easy. If an investor had bought technology sector fund in 2007, the three-year average return, according to Morningstar, was just 7%. In contrast, the three-year average return on the Pharma sector was 20%.
Clearly, sector funds are attractive investment but risky. How then can investors take exposure to such funds?
Typical diversified funds have sector tilts. That is, a diversified fund may be overweight on technology sector if the portfolio manager believes that the sector would outperform the benchmark index. The excess returns or the alpha in such case is generated through the sector allocation decision.
Diversified sector exposure?
Individual investors can also engage in such sector allocation decision. How? An investor can, for instance, take higher exposure to a banking sector fund if she believes that the sector would do well in the next year.
Generating excess returns from sector allocation decision, however, requires forecasting models. For those investors who do not have the resources (time and/or skill), naive asset allocation would suffice.
Naive asset allocation is a two-step process. First, the investor has to choose sectors which have sector-specific funds. Second, the investor has to invest equally across all these sectors. No rebalancing is required thereafter. We call this equally-weighted multi-sector portfolio.
Of course, the investor still has to take an active decision- to choose funds in each sector. And fund selection is not easy. We, therefore, decided to see how a portfolio will perform if an investor had taken exposure to the (ex-post) worst performing fund in four different sectors - FMCG, pharma, banking and technology. We assumed that an investor would take exposure to just one fund in each sector.
Our assumption was based on the reasoning that exposure to more than one fund in a sector would only lead to fund diversification, not portfolio diversification. This is because pure sector funds tend to have similar portfolio within that sector.
Based on the ex-post returns of the worst-performing fund in each sector, the five-year holding period return on the equally-weighted multi-sector portfolio was 16%. This compared well with the 8% return on the worst performing diversified fund.
Conclusion
An equally-weighted multi-sector portfolio is not necessarily attractive. This is because the downside risk is high, as a sector fund could generate significant negative returns if that sector underperforms. Of course, unlike our assumption, investors will not have exposure to worst-performing fund in each sector. If the one or more of selected funds perform well, the portfolio returns could be better.
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