What we have learn from financial history is that we have created many financial instruments that put investors in danger. Like mortgage backed securities, trenches, credit default swaps,numerous types of derivatives and so on .
I truly believe that mutual funds are not one of those. Mutual funds are better alternative for any fixed income instruments like fixed deposits and recurring deposits .
But in order to create different varieties in mutual funds investment banks and other financial institutions created some mutual funds that are net losers for investors .
Sector or Thematic mutual funds are one of them. Although mutual funds fits very well between bank saving and active equity investments but Sector Funds does not seems to fit in this .
Anomalies in sector and thematic funds .
Lack of choices in sector mutual funds
Unlike developed countries like India there are very less choices for sector of thematic funds. Most of these funds are concentrated to 3-4 sectors. Pharma, Technology, Utility and Power and Infrastructure are the sectors in which 90 percent of funds are concentrated.
Thematic Funds have very vague definitions for each funds like:Next Generation Fund.
- Which companies will qualify as Next Generation companies and why?
- Who factors will decide next their generation?
- Does selection of next generation companies assures return?
So institutions are just trying to offer different type of options irrespective of merits of funds .They are loading same few large caps just giving their fund different names.
Utility, Power, Infrastructure such type of sectors are matured sectors. They are not going to grow much faster than overall economy sometimes they may under perform to economy so there is no point in betting on such out of fashion sectors.
If investor want to ride a wave in any particular sector then there is huge chances that he will not find sector fund for this sector.
No Cyclical Sector Funds
If you want to take advantage of sector swings then cyclical industries are best for this. As cyclical sector moves in cycle creating many buying opportunities in downturn.
But it is not viable for any institutions to create and manage such kind of funds. Because in economic slowdown or when underlying commodity prices falls this stocks loose most of its value due to high volatility in prices.
Being a sector fund there is no backup of companies lying in other sectors. So in downtrend there is large risk that high redemption will take place creating liquidity problems .
High Expense Ratio
Purview of sector funds are very limited to few companies . It is also easy for managers to track these companies. Then also there is no difference in expenditure compared to other funds .
Expense ratio of such funds ranges from 2 percent to 2.5 percent.
Although this fee seems less but two things make it material .First compounding effect of such loss and second is that this fee is applicable irrespective of how fund performs i.e If NAV for fund loss its value for year then also investors have to pay fees.
What any sensible investor will do if he sees any growth in particular sector ahead . He will identify few good companies which have solid fundamentals and will stick to it till rally occurs .
But that not the way how mutual funds work here manager have to show some actions in order to justify his management compensation commission or salary.
This leads to high turnover in funds . Average portfolio turnover is 100 percent which means all stocks in portfolio changes in a year.
High turnover means high brokerage and transaction cost and higher the cost lower the returns . High turnover gives less time for company to show its growth.
Bad Track Record
Almost all the sector funds have failed to provide high returns for investors. Which shows flaws in overall concept of sector funds. Some pharma sector funds performed well but that due to COVID 19 impact. Corona Virus spread cause medical expenditure to increase and thus pharma companies have done good .
Such kind of events are unpredictable and extraordinary in nature which means that they will not occur frequently. Credit for pharma’s good track record goes to virus .
Focus on large cap stocks
Mutual funds managers get evaluated every quarter of sometimes every month .Which put lot of pressure on managers to outperform or at least to match the peers performance .
Because of which managers fear to bet on some less known stock (although it may have huge potential). So they prefer large cap stock as it moves in line with indices and there is very less short term downsize risk in it.