At Personalfn, we have never been great enthusiasts of sector-specific funds. Sector funds go against the very grain of mutual fund investing, which is diversification.

However, to give them credit, sector funds do imbibe the values of mutual fund investing - diversification across several stocks, albeit within the same sector. So for high risk investors who invest directly in stocks, sector funds can be a more prudent investment option.

FMCG funds have been in the limelight for some time now. As a matter of fact over 1-Yr (112.6 per cent) and 3-Yr (74.7 per cent CAGR), the BSE FMCG Index has even outperformed the broader BSE Sensex (73.7 per cent over 1-Yr and 55.4 per cent CAGR over 3-Yr). However, over 5-Yr, the BSE FMCG (24.8 per cent CAGR) trails the BSE Sensex (27.5 per cent CAGR). This tells the investor two things about FMCG funds, rather about sector funds in general:

• Over the short to medium term (1-3 years), a sector can outperform the market.
• Over the long-term (3-5 years), broad-based indices are likely to do significantly better than sectoral indices.
• Over the long-term (over 3-Yr), investors are better off investing in diversified equity funds. Informed investors who have a view on a particular sector (FMCG for instance) and understand when valuations are cheap and when they are stretched, can invest in a sector fund.

To be sure, the FMCG sector holds promise from a long-term perspective (over 5-Yr) for a variety of factors:

• Higher consumption of consumer goods
• Rising income levels
• Increase in rural penetration of FMCGs

Portfolio Strategy

FMCG funds have a limited number of companies to choose from given their sectoral constraints. So you have the usual suspects (ITC, Hindustan Lever [Get Quote], Dabur [Get Quote], Tata Tea [Get Quote] among others) dominating all three FMCG portfolios (at the time of writing this report).

Some FMCG funds have been a little innovative to expand their scope of investments to include non-related sectors like textiles and paints. That's how companies like Raymonds and Asian Paints [Get Quote] among others have made their way to FMCG fund portfolios.

In terms of market capitalisation, FMCG funds show no bias; they invest in companies across the market although leading FMCG companies (Hindustan Lever, ITC, Dabur to name a few) feature prominently in their portfolios.

Expectedly, in terms of diversification, FMCG funds fare very poorly. To begin with, there aren't too many stocks (the number hovers in the 10-20 range across FMCG Funds) in their portfolios given the limited number of listed FMCG companies.

Their portfolios are heavily concentrated with the top 10 stocks usually accounting for about 70 per cent of net assets. Magnum FMCG Fund for instance, had over 90 per cent of its assets in just 10 stocks. In our view, this is an extremely perilous situation for the investor, 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 (44.0% in top 10 stocks).

Performance

Evident from the table is the impressive performance posted by FMCG funds over the last year. The leading performer  - PruICICI FMCG (114.3 per cent) has outperformed all diversified equity funds in our sample over the 1-Yr time frame. However, over longer time frames of 3-Yr and 5-Yr, diversified equity funds have proved how diversification can be your biggest ally over the long-term.

Over 3-Yr, with the exception of PruICICI FMCG (75.0 per cent CAGR), FMCG funds have been outperformed by diversified equity funds. Over 5-Yr, our preferred diversified equity funds have comprehensively outperformed all FMCG funds.

Volatility

FMCG funds have outperformed their diversified peers in controlling volatility, a fact that is revealed by lower Standard Deviation figures for FMCG funds. All the FMCG funds have done significantly better than the diversified equity funds in keeping volatility on a leash. This is despite the fact that diversified equity funds have diversified across sectors and are better equipped to counter market turbulence. No wonder FMCG companies are referred to as defensive stocks.

Risk-adjusted returns

Another area where FMCG funds have stolen a march over diversified equity funds is in generating a superior risk-adjusted return (refer to higher Sharpe Ratios of FMCG funds). This can be attributed to the amazing run witnessed by FMCG stocks over the last 12-14 months. Compare the growth of the BSE FMCG (112.6 per cent) over the last 12 months vis-�-vis the BSE Sensex (73.7 per cent) and you begin to understand why FMCG funds have given superior absolute returns and risk-adjusted returns. The true trade-off however will be evident only over a 3-5 year timeframe.

Expenses

Surprisingly in terms of expenses, FMCG funds are at par with their diversified counterparts. In our view, FMCG funds should have lower expenses as compared to diversified equity funds because the fund management is related only to the FMCG sector which has a limited number of stocks.

Compare this to a diversified equity fund where the investment universe is much larger and therefore more resources are required to study the same. So it's only natural to expect that FMCG funds should incur lower charges vis-�-vis diversified equity funds.

Investors must consider the fact that net assets of FMCG funds is much lower than that of diversified equity funds, so there is lesser money to be managed and hence lower fund management costs.

Another reason why sector funds, including FMCG funds, should incur lower expenses is because there is relatively low churn. FMCG portfolios display a higher degree of consistency in stock picks compared to diversified equity funds where even the most conservative fund is like to witness some reallocation in terms of stocks and sectors.

Lower churn means lower trading costs, which should reflect by way of lower expenses. Unfortunately, the expense ratios of FMCG funds do not reflect this reality. As a matter of fact, HDFC Top 200 (2.20 per cent) has a lower expense ratio than all three FMCG funds under review.

Conclusion

As investors would have gathered, the FMCG sector has the potential to deliver above-average growth over the long term (3-5 years). However, this growth is likely to come at above-average risk to the investor given that portfolio diversification across stocks and sectors is not possible.

For investors with a high risk appetite who invest directly in FMCG stocks, FMCG funds are a superior long-term alternative.