The most important benefit that mutual funds offer to investors is the opportunity to diversify across sectors and market segments.

They work on the principle that the fund stands a better chance of delivering by investing in stocks belonging to various sectors and market segments. As a result, the fund manager is at liberty to choose stocks from an unrestricted investment universe.

Sector funds on the contrary, deprive investors of the benefit of diversification, which is the mainstay of diversified equity funds. The intention is to clock growth by capitalising on attractive growth opportunities from the designated sector.

The fund manager managing a sector fund is restricted in terms of selection of stocks, as he can invest in stocks only from the earmarked sector/theme.

In this article, we put pharma funds (funds which invest in stocks from the pharmaceutical sector) under the scanner, study their dynamics and find out how they fare against conventional diversified equity funds.

Portfolio strategy

Because of the sectoral constraints, sector funds typically have a limited number of stocks to choose from. As a result, they show the tendency to hold concentrated portfolios; and pharma funds are no different.

Broadly, the number of stocks in their portfolios hovers around 15-20, with the top 10 stocks accounting for over 70% of the assets in most cases.

In the pharma funds segment, Magnum Pharma (76.8% in top 10 stock holdings) emerges as the most concentrated fund followed by Franklin Pharma (73.7%) and UTI Pharma & Healthcare (70.1%).

On the contrary, funds from the diversified equity funds category score much better in terms of diversification across stocks. HDFC Top 200, with a top 10 stock holding of 40.2% is the most concentrated fund among diversified equity funds, while DSP ML Opportunities (34.7%) fares the best on this parameter.

Performance

Pharma funds have failed to impress on the returns front as well. As is evident from table above, over the 1-year time frame, the performance of pharma funds has been poor. Not only have the funds been comfortably outperformed by diversified equity funds, Franklin Pharma (21.8%) and UTI Pharma & Healthcare (15.7%) have failed to match the benchmark index BSE Healthcare (23.5%).

The 3-year and 5-year rankings paint a similar picture. Over the 3-year period, the only saving grace for the pharma funds segment is Magnum Pharma (44.1%), which has pitched in a performance comparable to that of diversified equity funds. In fact, it even outscores Sundaram Growth (43.2%).

Over the 5-year period, the performance of pharma funds is dismal and they substantially lag their peers from the diversified equity funds segment.

Volatility and risk-adjusted return

Pharma funds have also faltered in controlling volatility, which is evident from their high Standard Deviation figures.

Even the worst performer in the diversified equity funds segment i.e. Sundaram Growth (Standard Deviation 6.53%) fares better than all the pharma funds. Magnum Pharma (7.21%) pitches in the worst performance across segments.

In terms of risk-adjusted returns (which is measured by the Sharpe Ratio), diversified equity funds have again delivered a markedly superior performance. Effectively, pharma funds have failed to deliver despite having exposed investors to higher levels of risk.

Expenses

In terms of expenses, pharma funds rank above their diversified equity fund counterparts. This is mainly because pharma funds have relatively lower net assets. SEBI guidelines for expenses are loaded in favour of larger funds, i.e. larger funds incur lower expenses and vice versa.

Therefore the larger diversified funds in our sample -- HDFC Top 200 (2.13%) and DSP ML Opportunities (2.10%) have proved to be relatively more cost effective.

Conclusion

Our advice for investors remains unchanged -- unless you possess the necessary "expertise" to invest in a pharma fund, steer clear of it and instead invest in a well-managed diversified equity fund with an established track record.

Remember, diversified equity funds are equal to the task of identifying opportunities in the stock markets and that includes the 'pharma opportunity.'

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