Mutual Funds: Diversified or Sector focused

Diversified mutual funds are any day better than sector focused ones. Here’s why.

There are myriad options when it comes to choosing mutual fund schemes. But most equity funds fall under two buckets: diversified and sector focused. Diversified equity funds invest in shares of companies across industries: manufacturing, services, infrastructure, technology, consumer products etc. Sector focused equity funds on the other hand invest only in shares of companies in select industries that are pre-defined as per the mandate of the fund. Examples of sector-focused funds are Power Fund, Infrastructure Fund, Energy Fund etc. The question is - which category is safer and better for the long term.

Before we pass a verdict, let’s first try to define what’s the principal reason for people to invest in an equity mutual fund, which for all practical purpose is merely a conduit for investing in stocks. If you ask me, I would say it is their indisposition towards investing directly in stocks. Why else would people give their money to a third party to invest on their behalf? There is tax benefit, but I don’t think it’s the sole reason. So, assuming that we invest in equity mutual funds primarily because we feel inadequate to invest directly in stocks, the logical question is why then do we want to unnecessarily stick our neck out and choose a particular sector?

Here’s another way to look at the matter. Once we have decided to give our money to a mutual fund to pick stocks for us, would we rather have the fund pick stocks from a universe of 10 sectors or only from 1 sector? If the objective is to invest in stocks of the best companies at the best price, the larger the universe of sectors the better. Right? Given that a typical equity fund holds a portfolio of 20 to 30 stocks, the more the sectors the more the degrees of freedom available to the fund manager to choose the best stocks out there. In all my years of experience in investing, I have been unable to find more than 3 to 4 good companies in a single sector. Restricting a mutual fund to one or two sectors (the case with sector funds) means the fund manager is literally forced to buy stocks of crappy companies just to meet his portfolio target of at least 20 stocks. This process can be considered as being equivalent to adding sludge to raisins. Irrespective of the number of raisins, the end product is going to be “sludge”.

Sector funds usually become popular when a particular sector is “hot” i.e. when a lot of action is happening in the sector. Although rationally, this could probably be the worst time to invest in the sector. Even a sector with terrible long-term economics can become “hot” for a short period. This is exactly what happened to the textile sector a few years back. Most of the time, when a sector is “hot”, it implies investors are exuberant about that sector and this could lead to a bubble (inevitably followed by a burst!). Take the power sector today, for example. Many private power companies are coming out with IPOs and the already listed companies are raising further capital for mega-expansion plans. A lot of money is flowing into the sector to cater to the power shortage in our country. Obviously mutual funds that plan to focus on power sector are quite popular these days. What people fail to understand is that because of the pent up demand for stocks in power sector, most of them trade at very high valuations. While some of the stocks may actually deserve high valuations (assuming their rosy growth projections come true), many will fall by the wayside because of their inability to scale up, execute projects as per plan and operate efficiently. Afterall not all IT companies could become an Infosys, Wipro or TCS, could they? Investing in a Power fund today is similar to investing in a Tech fund in the year 1999. Although most Tech funds held stocks of Infosys, Wipro and TCS, they also held stocks of dozen other IT companies, some of which have since disappeared. This translated to pathetic performance of Tech funds, and tremendous wealth erosion for investors – a direct consequence of my “sludge” theory, discussed earlier.

In the short term, when a particular sector is in fashion, sector funds focusing on that sector will perform as if they are on steroids. But they may fall off the cliff anytime, wrecking their long-term performance. What matters in long term investing is identifying good companies and not what is “in” or “out” of fashion. Diversified funds are safer and better suited to accomplish this long-term objective compared to sector focused ones.