Sector Funds can be risky

Edelweiss Mutual Fund recently shared an important chart on Twitter about the returns of various sectors on a rotational basis. The chart covers the last twelve years and includes sectors such as real estate, capital goods, auto, consumer discretionary, utilities, pharma, telecom, FMCG, IT, metal, financial services, and the Nifty 500 Total Returns Index. The Nifty 500 Total Returns Index shows a Compound Annual Growth Rate (CAGR) of 15%. Most sectors are close to this return rate, except telecom, which has lagged in the last decade.

One key insight from the chart is that over a decade, regardless of the sector, the returns tend to converge around the same point. This means that while some sectors may outperform in certain years, they often underperform in others, balancing out over the long term. This pattern highlights the cyclical nature of sector performance and the importance of diversification in investments.

The Problem with Sector Funds

A common trend is that after a major run in any sector, many sector-specific funds are introduced. For example, there might be new funds for defense, electric vehicles (EV), shipping, or public sector enterprises after these sectors have already seen significant gains. The primary aim of these funds is to gather assets under management (AUM) rather than to deliver returns. This can lead to disappointing results for investors who buy into these funds after the sectors have peaked. Historical data shows that investing in a sector fund after a significant run-up can result in years of underperformance.

Caution with Sector Funds

Investors should approach sector funds with caution. Instead of buying into a single sector fund, consider a strategy that selects sectors based on their current strength and rotates out of them when they weaken. This approach can help avoid the pitfalls of investing in a sector that has already experienced its peak performance.

Benefits of Sector Rotation Strategy

A sector rotation strategy involves picking sectors based on their strength in the current year and shifting to other sectors as their strength wanes. This dynamic approach can potentially beat average returns over time by capitalizing on the best-performing sectors each year. For example, if a strategy had shifted into real estate, capital goods, or auto sectors in 2023, it would have performed well. Conversely, avoiding sectors like metals and financial services in certain years would have prevented underperformance.

To achieve market-beating returns, it’s essential to be in the right sectors each year. Sticking to a static sector allocation can lead to average returns at best. A dynamic approach that adapts to changing market conditions and rotates into the strongest sectors can provide better results. This strategy requires careful analysis and timely execution but can be rewarding in the long run.

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