The fallacies of sectoral funds

The Indian equity market, as a whole, has observed poor returns in the period since late 1995. In an environment with indifferent returns - overall - a few sectors have obtained excellent returns. The IT sector, in particular, has gone from being ignored by conservatives who thought that "real companies make real goods" and "require the backing of existing business families" to being one of the largest single industries in India. In this transition, IT stocks have obtained phenomenal returns. Other sectors which have fared unusually well include the pharmaceutical industry and the fast-moving consumer goods (FMCG) industry.

In recent months, there has been a flurry of mutual fund products which are "sectoral funds". These funds restrict themselves to only investing in one sector. An IT sectoral fund would only buy IT stocks. Does this make sense? Should an investor buy such products?

The dangers of extrapolation. By now, most people have digested the notion that if a stock did well in the past, this in no way implies that it will do well in the future. The same applies at a sectoral level. If an industry obtains strong positive returns in the past, this in no way predicts that it will obtain strong positive returns in the future. A basic blunder which underlies a lot of interest in sectoral funds is naive trend extrapolation - because IT stocks obtained strong positive returns in the last three years, it is hoped that they will also yield strong positive returns in the next three years.

It is important to make a distinction between the performance of IT companies and the performance of their share prices. I believe that it is very likely that Infosys will show strong growth in sales and profits in the three years to come. However, everyone in the country knows this too, so this information is already built into the share price of Infosys. The share price of Infosys can double in the next three years only if Infosys performs much better than present expectations, and surprises all of us. I can only justify being a speculator and buying Infosys if my perception about the future of Infosys is greatly more optimistic than the perception of the mass of stock market traders in India.

Heterogeneous sector-returns are perfectly normal. Many people have been astounded by the difference between the returns on one sector when compared with returns on the market index. Some have gone so far as to question the usefulness of the market index in India. However, differences between industry returns are fairly normal. An analogy might be made with the wholesale price index (WPI). There are hundreds of commodities in the WPI. There is a natural variation in the change in prices seen for each commodity. Hence, there will always be a few commodities showing a price rise which is much more than the overall WPI.

The same is the case with the stock market index and its underlying industry indexes. Even though individual industries can vary in their returns, there is a central role for an overall market index such as Nifty, which remains the best single measure of how the overall equity market is faring - it measures the returns obtained by owners of all Indian equity, as a whole. The fact that different industries will fare differently in the coming three years doesn't help us in forming investment strategies today, since we don't know more than the stock market about which industries will do better than others.

Sectoral funds are under-diversified. At the simplest, when an investor buys a Nifty index fund, he "pays" for the returns of equity by enduring the risk of index movements, which has a volatility of returns of around 1.4 percent per day. Here, since Nifty is a well diversified index, it obtains low risk by the canceling out of the different industries that go into the overall market index. In contrast, industry index funds suffer from greater risk by being under-diversified; the volatility of an industry index is typically in excess of 1.8 to 2 percent per day. They fail to exploit the natural opportunity for diversification - canceling out the fluctuations across different industries. An industry index fund is inferior to a Nifty index fund in exactly the same fashion that a Nifty index fund is inferior to a global index fund. Most sectoral funds in India are not index funds, so they suffer from additional risk and inconsistent performance.

The fallacy of actively managed sectoral funds. Active managers, or stock pickers, hope to obtain excess returns by trading in mispriced stocks. They hope to buy under-priced stocks and sell over-priced stocks. A normal actively managed fund, with no proclaimed sectoral bias, seeks to buy under-priced stocks wherever it sees them. This could sometimes mean buying many stocks in one sector -- a normal actively managed can become a sectoral fund anytime it wants to. An actively managed sectoral fund hopes to find more mispriced stocks by restricting the stock picker to only searching for underpriced stocks within one sector -- the actively managed sectoral fund cannot become a normal actively managed fund anytime it wants to. This is mathematically incorrect. By making the search universe smaller, we don't increase the number of mispriced stocks that could exist.

For most investors, plain index funds make sense. For almost all investors, the basic argument for owning equities is rooted in the fact that stocks outperform bonds on long horizons. This advantage of equities is fully harnessed using a broad-based index fund, such as a Nifty index fund. Betting on industry performance should not play an important part in the core investment strategy of most investors.

In conclusion. A sectoral fund is a bet. If it is an actively managed fund, it is a bet that a fund manager will find more gems by scanning fewer stones. A sectoral index fund is a bet that the inferior diversification of the sectoral fund will be outweighed by the superior returns that might come in the future; it is a bet that the market as whole has made a mistake in its valuation of the bulk of the stocks of the industry.

Who is the speculator for whom a sectoral fund makes sense? It is only possible to justify buying an actively managed sectoral fund if you believe that it is better to prevent the fund manager from doing stock picking in any other sector. It is only possible to justify buying a sectoral index fund today if you strongly believe that as of today, the market has under-estimated the future growth potential of that sector so badly that you are willing to suffer the additional idiosyncratic risk that comes from being under-diversified. Any interest in sectoral funds which is not directly justified by either of these two arguments reflects a failure of understanding. If you don't subscribe to either of the above notions, you are better off buying a Nifty index fund.

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