Sector funds have always a much-discussed mutual fund category. The reason for this has been the misconception that they can clock impressive growth in a short time-frame.

Sector funds mainly invest in companies from a single sector like pharma or technology, for instance. Although this helps the fund to tap the potential of a particular sector, this investment style goes against the basic philosophy of mutual fund investing i.e. it deprives investors of diversification across sectors. Thus although the principle of diversification does not work across sectors, this principle is evident across companies in a particular sector.

Among various sector funds, software funds are often the most popular. They have been in the limelight since the tech boom, way back in the year 1999-early 2000. It was during this period when a lot of AMCs (Asset Management Companies) launched software funds. Unfortunately, most of the sector funds were launched at the fag end of the tech rally. Consequently their performance slumped dramatically when the tech rally fizzled out by March 2000.

Third in our series of articles on mutual fund variants, we take a look at the dynamics of software/IT funds and how they have fared against conventional diversified equity funds.

Portfolio Strategy

Because of the sectoral constraints, software funds have limited number of companies to select from; the usual suspects are Infosys [Get Quote], Wipro [Get Quote] and TCS [Get Quote]. These funds normally invest in companies across market capitalisations.

But expectedly, in terms of diversification, software funds fare very poorly. The number of stocks in their portfolios hovers in the range of 10-20.

The portfolios of software funds are heavily concentrated with the top 10 stocks accounting for over 75% of net assets in most cases. Franklin Infotech Fund for instance, had 99.3% of its assets in just 9 stocks. Other software funds like UTI Software Fund (91.2%), Kotak Tech (86.0%) and Magnum IT Fund (78.5%) would also qualify as very concentrated.

This could be an extremely perilous situation for the investor especially during a market downturn, but that is the risk he takes while investing in a sector fund.

Diversified equity funds of course have it a lot better in terms of stock/sector choice. They invest across sectors and their portfolios are well-diversified. The most concentrated portfolio in our sample belonged to HDFC Top 200 (45.8% in top 10 stocks).

Performance

The performance of software funds has not been very impressive on the returns parameter. As is evident from the table, over the 1-year time frame, although software funds have delivered good returns they have been outperformed by diversified equity funds. Magnum IT Fund (45.4%) is the only software fund, which has a comparable performance vis-�-vis diversified equity funds.

Over 3-year horizon, the scenario is almost similar with diversified equity funds outperforming software funds. In fact some software funds under review � UTI Software Fund (45.6% CAGR) and Kotak Tech (41.2%) were outperformed by the benchmark BSE IT (48.2% CAGR). Over 5-year, the diversified equity funds under consideration have comprehensively outperformed all software funds.

Thus over longer time frames of 3-year and 5-year, diversified equity funds have made more money for the investor than software funds.

Volatility and risk-adjusted return

Software funds have outperformed their diversified peers in controlling volatility, which is apparent from their lower standard deviation figures. Almost all software funds have done considerably better than their diversified equity fund peers in keeping volatility on a leash, the only exception being Magnum IT Fund (Standard Deviation 7.54%) which is on the higher side.

This is despite the fact that diversified equity funds are diversified across sectors and are better equipped to tackle market turbulence.

In terms of risk-adjusted returns (which is measured by the Sharpe Ratio), diversified equity funds have put in a markedly superior performance. This implies that as compared to software funds, diversified equity funds have generated a higher return per unit of risk.

Expenses

In terms of expenses, surprisingly software funds are at par with their diversified counterparts. In our view, the expense of software funds should ideally be less than diversified equity funds because the fund management is related only to the software sector, which has a limited number of stocks.

On the contrary diversified equity funds have a much larger investment universe and hence require more resources to study the same. So software funds should have a lower expense ratio vis-�-vis diversified equity funds. Also the net asset of software funds is much lower than that of diversified equity funds, so there is lesser money to be managed and hence lower management costs.

As investors would have gathered by now, apart from providing investors the opportunity to capture the growth in the software sector, software funds have little value to offer. Consequently, for retail investors, conventional well-diversified equity funds continue to be the best bet. Thanks to the broad investment mandate, the fund manager has the option to invest in stocks across sectors including the ones held in software funds.

Also the fund manager has the liberty to invest in different sectors, if one sector turns unattractive. The fund manager of a sector fund is devoid of this liberty, as it would amount to breach of mandate.

A lot of investors find the appeal of sector funds irresistible, which is fine if you have an informed view on the underlying sector and can understand the intricacies of investing therein.

Such investors will be able to accurately time the entry and exit of their investments and thereby best utilise the opportunities in a given sector.

As always, our advice to investors is to steer clear of sector funds and rather invest in well-managed diversified equity funds. Having said that, for investors with a high risk appetite who invest directly in software stocks, software funds can be another long-term alternative for them.

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