What Are Sector Funds?

Think about how your neighbourhood kirana store works. It stocks everything from dal and rice to soaps and biscuits. Now compare this to a shop that sells only mobile phones. The kirana store has steady business because if one product doesn’t sell, others will. But the mobile shop’s fortunes depend entirely on how the phone market performs. When new models launch during Diwali, business booms. During slow months, the owner waits it out.

Sector funds work like that mobile phone shop. They put all their money into one specific industry, betting entirely on its performance. This focus can lead to spectacular gains when the sector does well. But it can also mean painful losses when things go south.

Let’s understand what sector funds really are, how they work, and whether they make sense for your investment portfolio.

The Basic Concept

A sector fund is a mutual fund or exchange-traded fund (ETF) that invests only in companies belonging to a single industry. So a banking sector fund buys shares exclusively in banks like HDFC Bank, ICICI Bank, Kotak, or SBI. A pharmaceutical sector fund invests only in companies like Sun Pharma, Cipla, Lupin, or Dr. Reddy’s. An information technology sector fund focuses on Infosys, TCS, Wipro, HCL Tech, and similar companies.

This is fundamentally different from a diversified equity fund. A diversified fund spreads your money across banking, FMCG, automobiles, pharma, IT, and other sectors. The fund manager has freedom to move money between industries based on where opportunities look best. With sector funds, that flexibility doesn’t exist. If the fund is called a “banking fund,” it must invest in banking stocks regardless of whether the manager thinks banks will do well or not.

In India, SEBI (Securities and Exchange Board of India) has classified sector funds under the “sectoral/thematic” category. These funds must invest at least 80% of their total assets in companies from their designated sector. This regulation ensures transparency. When you buy an infrastructure fund, you actually get infrastructure stocks, not something else entirely.

Popular Sector Fund Categories in India

1. Banking and Financial Services Funds. These invest in banks, NBFCs (non-banking financial companies), insurance companies, and other financial institutions. Given that banking is the largest sector in Indian indices, these funds attract significant investor interest.

2. Information Technology Funds. These focus on software services companies, IT consulting firms, and technology product companies. Indian IT funds benefited enormously during 2020-21 when digital transformation accelerated globally.

3. Pharmaceutical and Healthcare Funds. These invest in drug manufacturers, hospitals, diagnostic companies, and medical device makers. The pandemic brought renewed attention to this sector.

4. Infrastructure Funds. These focus on companies involved in construction, cement, capital goods, power, and related industries. Government spending on roads, railways, and urban development drives interest in these funds.

5. Consumption Funds. These invest in FMCG companies, retail businesses, consumer durables, and other firms that benefit from rising consumer spending in India.

6. Energy and Power Funds. These include traditional energy companies as well as newer renewable energy businesses.

Why Investors Choose Sector Funds

1. Targeted exposure to high-conviction ideas. Sometimes you develop a strong view about a particular industry’s prospects. You might believe that India’s growing middle class will boost consumption spending for decades. Or you might think that government infrastructure push will benefit construction companies significantly. Sector funds let you act on such views without picking individual stocks yourself.

2. Participation in emerging growth themes. New opportunities keep emerging as India’s economy evolves. Electric vehicles, digital payments, clean energy, and data centres are examples of themes gaining momentum. Sector funds focused on these areas let you invest in growth stories early. The fund manager handles the research and stock selection.

3. Potential for higher returns during sector rallies. When a particular sector catches fire, diversified funds capture only part of the gains because they hold many other stocks too. Sector funds capture the full upside. During the IT boom of 2020-21, some technology sector funds delivered returns exceeding 60-70%. Investors specifically allocated to these funds gained substantially more than those holding only diversified funds.

4. Portfolio customisation. If you already own a diversified fund that’s underweight on a sector you like, you can add a sector fund to increase your exposure. This gives you more control over your overall asset allocation.

The Risks You Must Understand

Sector funds carry meaningfully higher risk than diversified funds. This is the trade-off for their potential to deliver higher returns.

1. Concentration risk is the primary concern. When all your money sits in one industry, you’re completely exposed to anything that affects that industry. Regulatory changes can hurt. Global events can create problems. Technological disruption can make business models obsolete. During 2018-19, pharma sector funds struggled badly because of pricing pressures in the US market and FDA regulatory issues. Investors who had significant money in pharma funds experienced years of disappointing performance.

2. Timing becomes extremely critical. With diversified funds, systematic investing works well because you’re spreading risk across sectors automatically. With sector funds, when you enter and exit matters enormously. If you invest at the peak of a sector cycle, recovery might take years. Infrastructure funds that attracted money during the 2007 bull market took more than a decade to recover after the 2008 crash. Many investors gave up and sold at losses during this period.

3. Cyclical sectors test your patience severely. Industries like banking, real estate, metals, and infrastructure move through extended cycles of good and bad times. A banking fund might perform brilliantly for three years, then struggle for the next two or three. If you lack patience to hold through difficult periods, you’ll likely sell at exactly the wrong moment, turning temporary underperformance into permanent losses.

4. Sector rotation works against you. Market leadership keeps shifting between sectors. IT might lead one year, banking the next, and pharma the year after. Last year’s best-performing sector fund often becomes this year’s laggard. Chasing past returns in sector funds almost never works out well.

How to Use Sector Funds Sensibly

The most practical approach is treating sector funds as additions to your core portfolio, not replacements for it. Your foundation should remain diversified equity funds that automatically spread risk across industries. Think of sector funds as the pickle alongside your main meal. The pickle adds flavour and variety, but you wouldn’t eat only pickle for lunch.

1. Keep allocation limited. Most wealth managers recommend restricting sector fund exposure to 10-15% of your total equity portfolio. This approach gives you meaningful upside if your sector view proves correct. But it also protects your overall wealth if the sector disappoints. You participate in gains without risking everything.

2. Invest based on genuine understanding, not recent performance. Don’t buy a sector fund simply because it topped last year’s return rankings. Sectors rotate constantly, and past winners frequently become future underperformers. Instead, invest when you have a clear view on why a sector will do well over the coming years. If you believe India’s digital economy will keep expanding rapidly, a technology or financial services fund might make sense. But ensure you understand the reasoning behind your investment.

3. Maintain a long holding period. Sector funds require patience. Economic themes and industry trends take time to play out fully. If you invest in an infrastructure fund because you expect government capital expenditure to drive growth, give that thesis at least three to five years. Short-term trading in sector funds typically destroys value rather than creating it.

4. Rebalance when allocations drift. After a good run, your sector fund might grow to become 20-25% of your portfolio from an initial 10%. This is the time to book partial profits and bring the allocation back to your target level. This discipline prevents dangerous overexposure to a single sector right when it might be peaking.

Who Should Consider Sector Funds?

Sector funds suit investors who have already built a solid diversified portfolio and want to express specific views on certain industries. They also work well for people with professional expertise in particular sectors. A banker might understand financial services trends better than most. A doctor might have genuine insights into pharmaceutical industry dynamics. This knowledge edge can help with both entry timing and holding through difficult periods.

If you’re relatively new to investing or prefer a simple approach that doesn’t require active monitoring, diversified equity funds remain your better choice. They give you automatic sector diversification and need far less attention.

To Sum Up

Sector funds offer concentrated exposure to specific industries. They can deliver outstanding returns when your chosen sector performs well. But they also carry higher risk because you’re not spreading your bets across the economy.

For practical application, consider allocating a small portion of your equity portfolio perhaps 10% or so to one or two sectors where you have genuine conviction about long-term structural growth. Keep following industry developments, and be prepared to hold through periods of underperformance. Used with discipline and patience, sector funds can meaningfully enhance your portfolio returns without putting your overall financial goals at excessive risk.