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Wednesday, August 8, 2018

Sectoral Funds are more Volatility

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This is the kind of period in time that is an essential part of an investor's education. Equity fund investors across the board are learning a lesson in facing volatility with fortitude. At the same time, there are some false takeaways that you need to avoid. Probably, the worst lesson that can be learnt is that when the markets are down, some sectors still do well and the best approach is to identify the correct sectoral funds.


Right now, if you go to Value Research Online and look at the returns of different fund categories over various periods, you would come to one of two very different conclusions. You could either infer that it is a volatile period and as equity investors you just have to weather occasional bouts of unpredictability. Or, you could surmise that technology (and possibly FMCG) sector funds are doing well, and that if you had known this secret, you would have invested only in these funds.

Whenever a particular type of stock is doing well, a number of supposedly professional advisers decide to tell investors that this is where they should make their investments. Sellers start pushing funds that focus on that sector, seeing a clear opportunity if the trend continues.

For some time, the trend does hold. At this point, it investing in a diversified way seems like an inferior option. The difficult thing to understand is that this is actually happening almost constantly. The equity market, as a whole, is always a composite of sectors that are facing varying fortunes. Whether the markets are stable or volatile, rising or falling, one sector or the other is always certain to be doing better than average. This makes it highly likely that a diversified mutual fund portfolio will always look like a sub-optimal choice.

However, the law of averages inevitably asserts itself and the sector(s) that were doing well start performing below average, and their returns revert to the mean. Those who jumped on to the bandwagon late are left with the worst results. In fact, the math is generally even harsher. The reversion to mean often results in the formerly best sectors falling to the absolute bottom. This creates losses even when the rest of the market is booming. Former cheerleaders of the tech, infra and many other sectors have learnt this the hard way. However, if you see the excitement today, it becomes obvious that these lessons have been unlearned by many.


Does this mean that investors should avoid sectors that are doing well? That is also a recipe for low returns. In either case, investing on the basis of momentum is not the smart thing to do. What is the alternative?


The simple answer is that investors should let the investment manager of a diversified equity fund make the choice. After all, the main reason for investing in mutual funds is to get the services of an investment manager who does the research and makes the choices for you. If you have to track the markets yourself, what is the point of investing in mutual funds?

As I've discussed earlier in this column, volatility is a part and parcel of investing in any equity-based product. It is pointless to over-analyse a particular period of volatility. Today, it is interest rates and Trump's impending trade war, tomorrow it could be something else. It doesn't matter. Periodically, something or the other will inevitably come up. The best course of action is to identify this issue as the non-issue that it is.

 


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