Equity fund investors have a reason to be happy as markets test new highs every other day. Diversified funds, which invest across sectors, have done well but some of the sector funds have done better in the past year.

The fact is fund managers are bullish on most sectors, which makes a strong enough case for a sectoral allocation. While no one is suggesting that putting all the eggs in one basket is a good idea, a well-thought out portfolio strategy, combining the benefits of diversification as well as a limited allocation to select sectors with a positive outlook may be worth a try.

Even if you go by performance alone, it is a sector fund category that has been topping the table in equity fund categories. The FMCG fund category has been the best performer among equity funds over the past year, providing an average return of 66.81 per cent. This was followed by tax planning funds (58.53 per cent) and diversified funds (53.29 per cent).

Sector fund categories such as auto (50.96 per cent) and technology (42.15 per cent) have also done pretty well. The only categories to return less than 40 per cent are pharma funds (31.01 per cent) and petroleum funds (24.19 per cent) apart from index funds.

Making their mark

In the vast universe of equity funds, there are any number of sector schemes that are in the top quartile. Prudential ICICI FMCG Fund was, in fact, the best performing equity scheme for a long time, till it was replaced at the top recently by SBI [Get Quote] Magnum Tax Gain.

Even now, the FMCG fund is the second best among all equity schemes with a one-year return of 98.81 per cent. Other sector funds, which have performed well over the past year include Reliance [Get Quote] Diversified Power Fund (90.33 per cent), Birla Sun Life Buy India Fund (68.98 per cent) and Franklin FMCG Fund (68.13 per cent).

In fact, if one looks at a short-term scenario, sector funds have done very well. Among the top 10 performers in the last six months, four are sector funds. Again, Prudential ICICI FMCG Fund (44.35 per cent) is second behind SBI's Magnum Multiplier Plus, followed by Reliance Diversified Power (43.39 per cent) and SBI Magnum Sector Umbrella -- Infotech (53.37 per cent).

But before we draw any conclusions, it has to be kept in mind that a sectoral allocation has to be done judiciously. There are any number of sectoral schemes, which are languishing at the bottom too, mainly belonging to the pharma and oil & gas sectors.

The performance of JM Basic (18.71 per cent), UTI Growth Sector Fund -- Pharma and Healthcare (23.63 per cent), Kotak Tech Fund (26.49 per cent), JM Healthcare (24.96 per cent), Franklin Pharma (25.80 per cent) will throw this strategy out of the window.

Look before you leap

So how does one go about choosing a sector fund? First of all, one would do well to remember that investing in sector funds is a risky proposition at the best of times. Since the allocation in these funds is in a single sector, it doesn't offer a diversified portfolio, which mitigates the risk factor.

One example is the rush for investing in technology funds, just when the tech boom was about to burst. Since mutual funds tend to launch sectoral schemes when the valuations are on the way up, the chances for portfolio appreciation is limited.

Also, even if a fund sticks to its investment objective, it has to be kept in mind that given the small universe of stocks that it has to choose from in a particular sector, the return may witness excessive volatility over a period of time. Though the potential returns may be very good, investors have to keep in mind the risk they are taking in their books.

Keeping this in mind, investment advisors suggest that it is always better to take a long term investment view in sector funds. While fund managers advise that this is true for all equity funds, it is more so in sector funds, because every sector is known to go through its ups and downs.

"Sector funds are ideally suited for informed investors seeking growth in a time horizon of three to five years through investment in shares of well-managed companies with good prospects," says Sukumar Rajah, chief investment officer -- equity of Franklin Templeton Mutual Fund.

He adds that investors should look at these funds as an add-on to enhance their overall return to an already diversified portfolio.

"Sectors tend to perform at different points in time. For example, pharma sector funds are subdued right now. But FMCG funds are doing exceptionally well this year, despite not doing well in the past two-three years," says N Sethuram Iyer, chief investment officer of SBI Mutual Fund.

"So to get the best out of sector funds, investors need to be informed and have to get in at the right time," he adds.

The best policy to reap the rewards in a sector fund is to stay invested, wait for the downturn to pass before it comes out on top again.

According to Hemant Rustagi, CEO of Mumbai-based Wiseinvest Advisors, a financial advisory firm, investing in sectoral funds is fraught with risks unless a person is very familiar with equity investing.

"We advise a sectoral allocation to investors who have already been in the markets," says he. Also, Rustagi notes that only people with a large enough portfolio which can withstand any dramatic downturn in the fortunes of a sector fund should invest in them. "Risk bearing capability is critical when it comes to investing in these funds," he adds.

Investment analysts also caution against blindly going in for new sectoral fund offerings. As Iyer points out, sector funds are purely for those investors who are well informed about the sector. "They are more risky, but if one stays invested for a longer period, the return potential can be very attractive," he thinks.

"It is fine to invest in a sector if one knows about it and has the risk taking capacity. But even then, sectoral allocation should be done, looking at a fund's track record and their portfolio allocation," notes Rustagi.

Basically it would be a better idea to invest in sector funds that have been around for a long time and has a consistent portfolio. According to Rajah, these funds are not complete investment solutions. "Investors must remember that sector funds provide the opportunity to invest in one area of the market.

But if that strategy is used as the sole means of achieving higher returns, the investor must be willing to take the risk that accompanies the possible return."

To sum it up, having a sectoral allocation is alright if one knows the sector well enough and has the risk-taking ability. However, even then, it won't be a bad idea to diversify your risks through investing in a variety of fund types and thus a reduction in overall risk. After all, why put all your eggs in one basket?

Here is a look at various equity sector categories:

The FMCG funds have been the best performing among all equity categories, including diversified funds in the past year. The category returned 66.81 per cent on an average over the past year, with the top performing Prudential ICICI FMCG fund returning 98.81 per cent.

Out of the five schemes in the category, three have outperformed the benchmark BSE FMCG index in the past year, which returned 50.65 per cent. Over a two-year period all schemes have outperformed the index.

The outperformance can clearly be attributed to the fact that the schemes have taken a lower exposure to index heavyweight Hindustan Lever [Get Quote].

Funds have studiously avoided HLL, which gained 27 per cent in the past 12-months while taking exposure to such stocks as ITC (59 per cent), Godrej [Get Quote] Consumer (100 per cent), Asian paints [Get Quote] (73 per cent) and Pantaloon [Get Quote] Retail (218 per cent). Even though, classified as FMCG, these funds have also taken exposure to stocks in other sectors, which have aided their returns.

For example, UTI Growth Sector Fund -- Brand Value is not an out and out FMCG fund, with their top exposures being in State Bank of India, Bharti Tele-Ventures and Satyam [Get Quote] Computers. Similarly, Birla Sun Life Buy India has stocks such as Pantaloon Retail, Trent, Biocon [Get Quote] and Cipla in its portfolio.

With the sector outlook continuing to be promising, FMCG funds are expected to do well going forward. Rajah of Franklin Templeton notes that the cyclical recovery in the sector appears to be underway with a combination of increasing incomes, improved marketing and innovation by companies and better price value equation.

"We believe that future growth in the sector will be dependent on two structural drivers - increasing penetration and consumption in rural areas and catering to the changing aspirational values of the urban markets, along with the ability to take advantage of emerging opportunities through innovative products. The increased investments in rural infrastructure and improvement in farm production are expected to drive rural incomes, while the robust non-farm GDP growth is increasing urban incomes and changing lifestyles. Overall, we are positive about the long term prospects," he adds.

There are only two banking sector funds, viz, Reliance banking fund and UTI Thematic Banking fund. While the former has managed a return of 54.46 per cent over the past year, comfortably outpacing the benchmark index, BSE Bankex (46.81 per cent), UTI Thematic Banking Sector fund (41.84 per cent), in its relatively shorter life span has performed well too.

Both banks have SBI and ICICI Bank [Get Quote] has their top holding, while the allocation to other biggie, HDFC Bank [Get Quote] has been limited.

According to fund manager of UTI Banking Sector Fund, Gautami Desai, the worst seems to be over for the banking sector.

"The transfer of government securities to HTM (held to maturity category) has de-risked the investment portfolio from the interest rate movements. One time expenses such as hit on the investment portfolio, wage revision arrears, VRS expenses etc. are not expected in FY06," she says.

According to Desai, with the healthy growth rate in the advances portfolio, earnings are expected to grow by a minimum of 20 per cent in FY06.

If there is one thing that stands out about the portfolio allocation about technology funds, it is their love for Infosys [Get Quote] Technologies. Tech funds still think Infy is the counter to be in. Sure enough almost al the technology funds have Infosys as their top holding.

The stock has appreciated by nearly 30 per cent in the past year. SBI Magnum Sector -- Infotech has been the best performer in the category, with a yearly return of 53.37 per cent.

The fund's stock selection has differed from others, who have preferred a mostly conservative large-cap oriented portfolio. Though SBI's fund has Infosys as the top holding at 27.598 per cent, its other top holdings include mid-caps such as Infotech Enterprises [Get Quote], KPIT Cummins and Crest Animation.

While Infotech Enterpeises stock has seen a 140 per cent appreciation in stock price, those in KPIT Cummins and Crest Animation amounted to 26 per cent and 91 per cent respectively, which led to the impressive returns. As for the rest, top exposure followed a familiar pattern, with Infosys, TCS [Get Quote], Wipro [Get Quote] and Satyam figuring prominently.

Birla SunLife New Millennium (52.24 per cent) and DSP Merrill Lynch Technology.com fund (48.56 per cent) are the next best. Al sectoral funds except Kotak Tech fund has outperformed the benchmark BSE IT index (31.35 per cent). The performance over a two-year period has been impressive too, with the best performing Birla SunLife New Millennium fund (44.81 per cent) posting the maximum returns.

"Earning numbers from the top rung software companies in particular have been strong and they seem to be benefiting from stable-to-positive billing rates, strong volume growth and traction in key verticals.

"These companies have been garnering larger deals in recent months and the strong headcount addition points to increased visibility," notes Rajah.

In the past few years, the leading players have been consciously improving the geographical diversification of their client base and this has helped in cushioning the impact of currency movements.

While verticals such as banking and finance, manufacturing and retail continue to be the largest contributors to revenues, utilities and healthcare are the emerging focus areas. Indian companies are also focusing on developing newer offerings like testing, infrastructure and products to move up the value chain and take on incumbent MNC players.

"We continue to believe that larger companies in the sector are better poised to take advantage of the growing global demand," notes Rajah.

Pharma sector has been among the least impressive -- albeit on a comparative basis- in the past year. The category average for the past year amounted to 31.01 per cent, with only petroleum sector funds behind them.

Again, SBI Mutual Fund's pharma sector fund topped the tables, with a 43.56 per cent return over the past year, followed by Reliance Pharma fund (37.11 per cent). The former has put in an impressive performance for the past two-year period too, with a return of 49.55 per cent.

One positive factor for the category has been that all funds have outperformed the benchmark BSE Health Care index over a period of time.

The portfolio allocation has tended towards mid-caps, which have seen more growth towards large caps. Cipla and Glaxo SmithKline Pharma have been two large caps who have been near the top of portfolio, while fund managers have largely ignored old favourites Dr Reddy's Laboratories and Ranbaxy [Get Quote].

Rajah notes that there has been a significant capacity build-up in the generics industry across the globe, which is typical of low-entry-barrier commodity industries when profit cycles are near their peaks.

"Ironically most of this increase has come from second run Indian companies as reflected in growing capex levels and the rising number of ANDA/DMF filings. In addition to this, authorised generics have added to the pressure," he adds.

"These pressures are likely to lead to consolidation and fundamentally strong Indian companies with the expertise and distribution reach are well placed to take advantage of opportunities present in the R&D, outsourcing, contract manufacturing and domestic healthcare markets over the medium to long term."

The category has long been among the laggards among equity funds. The two funds in the category, JM Basic Fund (18.71 per cent) and UTI Growth Sector fund -- Petro (29.67 per cent) has underperformed the benchmark BSE Oil & Gas index (38.59 per cent) over the past year, as well as the past six month period.

Given the uncertainty regarding disinvestment of PSU oil majors as well as high oil prices, the sector performance has been dull. Though valuations are considered to be attractive given the lack of 'kickers' in the sector, it is anybody's guess as to when the category performance will improve.

Others

Among other categories, Reliance Diversified Power Fund has been the best of the lot with a return of 90.33 per cent in the past year. UTI's Basic Industries fund (67.90 per cent) and Auto Sector fund (48.86 per cent) have also shown impressive returns.

Given the expected growth in power sector thanks to large infrastructure spending and favourable policies, the outlook on stocks in the segment is bullish. Auto sector is expected to witness growth too.

"Auto companies have been showing strong sales growth across all segments," says Chandraprakash Padiyar, fund manager of UTI Auto Sector fund.