Sector funds have been the bugbear of many an investor. Their legacy from 1999-2000 is still fresh in the minds of investors and there is reservation to invest in them going forward.

While some investors nevertheless muster the courage to invest in them, this is often on impulse or a hot tip from the neighbourhood broker or the like. In other words, there is little thought process, if at all. On our part, we have tried to find a method in the madness.

Make no mistake; this is not about glorifying sector funds. Far from it! This is about defining, rather redefining, how sector funds can be used to meet one's investment objectives.

Historically, the problem with sector funds was not the high-risk involved, it was a problem of the high-risk not being conveyed adequately to the retail investor.

Consequently they got projected as a sure-fire mantra to clock above average growth at average risk. Since the premise was flawed, the disastrous results were not surprising.

But what if we change the premise? Will that help show sector funds in a 'different' light? We will let the experts answer this question. Mr Prashant Jain (Head-Equity, HDFC Mutual Fund) asserts, 'Sectoral funds are suitable for the initiated, sophisticated investor who has a view on a particular sector and knows when to enter and exit.'

The question is if sector funds are risky and can yet find a place in investor portfolios, how does one grapple with this contradiction? Having a large portion of your assets in sector funds is without doubt a  high-risk strategy that you would do well to avoid.

However, smaller exposures (about 5 per cent of the total investible surplus even for the aggressive investor) to sector funds may actually prove rewarding. Let us see how:

• For an aggressive investor who invests directly in the stock markets, and takes stock and sector-specific risks, sector funds help him dilute both these risks. Say for instance Mr Aggressive Investor has an investible surplus of Rs 1,000,000 and decides to invest Rs 50,000 in just one pharma stock, lets say Ranbaxy. This would involve active tracking of the stock and the sector to make the investment worth his while. Even then the risk of owning 5 per cent in a single stock isn't exactly a prudent decision. What he can do is invest an equal or a slightly lower sun in a pharma fund. That way the risk is diversified across about 15 stocks. So while the sector risk (in pharma) remains the same, the stock risk (in Ranbaxy) is diluted considerably.
• This is what a pharma fund can do for him if he wants to invest in just one pharma stock. If he wants to invest in several pharma stocks, then a pharma fund is not just a recommended solution, it is a must, because he is unlikely to manage his pharma portfolio as competently as a pharma fund manager.
• If Mr Aggressive Investor has a view on sectors like banking, software, pharma and petroleum, then sector funds can serve him equally well. Instead of investing in individual stocks across these sectors, investing in the sector funds would help him diversify across over 50 stocks in these four sectors. He can determine his allocation to each sector and invest accordingly in a bouquet of sector funds. If he had to do this by investing directly in individual stocks across these four sectors it would become cumbersome and time-consuming.
• If Mr Aggressive Investor is sure of a sector's potential but is not aware of which companies are best placed to exploit the opportunities within the sector, then a sector fund is the answer to his dilemma. For instance, Mr Aggressive Investor has heard of the great BPO (business processing outsourcing) opportunity but doesn't really know the companies that are in the forefront within the segment. He can leave the stock selection in the hands of an experienced and competent software fund manager by investing in a software fund.

Having drawn some strategies around sector funds, the investor must note that the fundamental premise still remains the same.

The investor still needs to be aware of the sector developments and book profits at regular intervals whenever there is an uptick in the net asset values.

Otherwise, he may find himself at the same level after two or three years (as has been the experience in the past). As we have seen, sector funds do not deliver over the long-term (3-5 years) but perform in short bursts of 3-6 months, that too at infrequent intervals (not to say they never will).

If the investor finds the active monitoring of sectors a burdensome task, then he should stick to diversified equity funds and spread his risks across a wider gamut of sectors.

A good sector fund must ideally:

• Have at least 15- stocks in the portfolio.
• Not have more than 60 per cent of net assets in the top 10 stocks.
• Be well-diversified across segments within the sector.
• Have an expense ratio of less than 2.50 per cent, which is how most diversified equity funds are placed.
• Have an asset base of at least Rs 500 m so as to benefit from scale economies.