Are your chances of finding a diamond better if you scan 10 heaps of charcoal or a thousand? More the coal you scan, higher your chances of finding diamonds. This is no rocket science.

However, sector funds which invest in a single industry sector defy this logic. They mandate their entire corpus to be invested in a single sector, be it information technology (IT), auto, pharmaceuticals or banking.

Sector funds focus their investments on a particular area and provide an opportunity to profit from trends impacting a particular sector industry.

Mutual fund houses offer a variety of sector funds to meet the requirements of investors who feel bullish about a particular sector. For instance, you might want to tap into the BPO boom in the IT/ITES sector, but your diversified equity fund invests only 10 per cent of its corpus in the sector. To allow you to have a higher exposure to the sector of your choice, fund houses offer sector-specific funds.

High risk, high return

By their very definition, sector funds are not diversified. So, the performance of the chosen sector determines the fortunes of funds. If the sector is headed north, the portfolio in the sector scheme gains. But if the sector is faring badly, the portfolio loses as the stocks in the sector lose sheen.

The IT sector boom is a classic example. For a year from October 1998, the Franklin Infotech Fund, which invested purely in the technology sector, returned almost 250 per cent. Many fund houses launched similar schemes. Even plain-vanilla diversified equity funds tilted their portfolios heavily towards the technology sectors. By 2000, when the technology sector began losing steam, performance of the IT sector funds started slipping.

Till finally when the tech bubble burst, most of the funds betting on this sector yielded negative returns. Investors who chased the 'hot' sector lost as much as 73 per cent of their capital (See table: Tech Bust).

It's a different story that some tech funds tried to arrest the downfall by altering their investment objectives from being sector funds to thematic funds. These included big names like Birla India Opportunities Fund, DBS Chola Opportunities Fund and UTI India Advantage. But since it usually takes time to make significant changes in the portfolio, they could not insulate the investors from the impact totally.

Over the past year, these funds have yielded 34.7 per cent, 17.1 per cent and 15.1 per cent, respectively, as compared to the 43.8 per cent returns posted by the BSE Sensex.

Though in this case the sector-focus led to losses, it encapsulates the essence of sector funds. During a sector upturn, a sector fund outperforms its diversified peers.

For example, for the period 1 April 2005 to 31 March 2006, Prudential ICICI FMCG (fast-moving consumer goods) Fund gave a return of 116 per cent, whereas the top diversified equity fund, SBI Magnum Multiplier, yielded 108 per cent.

Similarly, when Franklin Infotech Fund yielded 250 per cent, the top diversified equity fund yielded only 174 per cent. This means that if you can deftly time your entry and exit points in sector funds, you can laugh your way to the bank.

Predicting the peaks and troughs in any business cycle to perfection is a tough call. So, while sector funds are in the high-risk and high-return zone, over a long term, diversified equity funds tend to outperform sector funds with a big margin (See table: Sector vs Diversified).

Should you invest?

An exposure to sector funds can be profitable and yield higher returns if you choose wisely. For example, the banking sector has been in the news of late as the industry expects the sector to consolidate on account of mergers and acquisitions in the next three to five years.

If that eventually happens, it is widely expected that banks would benefit on account of consolidation. You might want to eat your share of this pie if you believe in this story. In which case, we suggest that you opt for a banking sector fund.

You will get the benefit of a larger basket of banking stocks as the schemes are able to invest in more scrips than a small retail investor. Also, it takes away the botheration of selecting individual stocks. This would give your portfolio the desired exposure to the sector and the potential upside.

Sector funds help you invest in a broader spectrum of that sector and, hence, minimise company-specific risk.

Also, investing across different sector funds can help create a more diversified portfolio with a marginally higher risk-return equation than investing in well-diversified schemes or balanced funds. However, you must be clear about which sectors to invest in.

Says Sanjiv Shah, executive director, Benchmark MF: "An investor can diversify his risk by investing in a few sectors that are expected to do well. But he must not carry the logic to an extreme and invest in all the available sector funds as it will defeat the very rationale of investing in sector funds, which is focused exposure."

The caveat, however, is that the investor must be able to understand the dynamics of the sectors he wishes to invest in. "The investor must follow sector trends well enough to decide which sector to buy into and which one to exit or avoid. If he cannot do that, then he is better off investing in diversified equity funds," says Prashant Kothari, fund manager, Prudential ICICI FMCG Fund.

Of course, there are some limitations in the industry, especially in the Indian context. First, there aren't too many options available in the industry. Sector funds in India came up around 1999-2000. At that time, the space was full of IT, pharma and FMCG funds, as those sectors were the prevailing 'flavours.' Now, there are some other sector funds like banking and auto. More recently, innovative sector funds like Reliance Diversified Power Fund and Reliance Media and Entertainment Fund have been launched (See table: Available Options).

Second, the number of scrips available for investing within a particular sector is limited. Hence, the sector funds tend to be heavily exposed to a handful of well-managed companies' stocks. For instance, the Franklin Infotech Fund invests 38 per cent of its corpus in Infosys Technologies [Get Quote] and the top three holdings constitute 70 per cent of the entire portfolio. Also, if one wants exposure to, say the metals sector, then the investible universe gets restricted to about four quality stocks.

Again, there may be enough number of quality stocks to invest in but all of those might not be large caps. For instance, in the Franklin Pharma Fund, the exposure to large cap stocks is only 34 per cent and that in Prudential ICICI FMCG fund it is only 25 per cent. Small and mid-cap stocks are illiquid, and needless to say, they add an extra element of risk to the already risky sector funds.

Thematic funds as an option

Managing sector funds can be as daunting as making money out of them. While the market run in 2000 was more in the technology-intensive sectors, the recent bull-run saw several sectors shine. Diversified funds have therefore outperformed sectoral funds during this period, with a few exceptions of the latter shining. Mutual funds have been quick to adjust and a new breed of funds has come up.

So what is this new animal? Thematic funds that aim to invest in a bunch of sectors woven by a common objective. These funds follow a theme rather than just one sector. Say, infrastructure theme that runs across sectors like auto and auto ancillaries, computer software, metals and banking and finance or services industries that includes sectors like housing and construction, hotels, chemicals, plastics and pharmaceuticals.

So, if finding and tracking individual sectors seem like a daunting task, thematic funds is an easy alternative. These funds are not as watertight in the investment philosophy as the sector funds. These funds look to bridge the gap between sector and diversified funds. Although the fund manager's investment options remains restricted to a particular theme, he has a wider choice of sectors to choose from.

For example, the SBI Magnum COMMA fund invests in commodity stocks and, therefore, has exposure to various sectors like cement, chemicals, metals and paper -- a much wider option than, say, just a fund that would invest in a metals sector.

Of course, sometimes the portfolios in these funds bear semblance to those of diversified equity funds and a clear demarcation is not possible. For instance, several infrastructure funds do invest in bank stocks. Their rationale: banks are an integral part of the country's infrastructure as they lend funds to the infrastructure sector that helps spur the growth in sector.

Secondly, there is no clear demarcation of the investible sectors within various funds. For example, 50 per cent of the sectors that Prudential ICICI Growth Fund, a diversified equity fund, invests in are also termed as services industries for other group scheme, Prudential ICICI Services Industries Fund, which is a thematic fund.

Just like sector funds, thematic funds have a flip side. "Although a wide choice of sectors is available, thematic funds still follow a restricted strategy. For example, infrastructure funds cannot take exposure to pharma or the auto sector," says Kothari.

This restrictive strategy prevents these schemes from participating in certain booming sectors. That explains the reason for their underperformance vis-a-vis diversified equity funds. (See table: Thematic vs Diversified).

Passive fund managers argue that it is difficult for active funds to beat their benchmark consistently over the long term. So it is a better and a cheaper strategy to stay invested in the indices. The age-old debate of active and passive fund management that applies to diversified equity funds finds a place in sector funds as well. This is because even if you are buying into a sector fund, it still is subject to the fund managers' skill of stock selection.

By doing active management within a sector, they argue that higher value can be found in a set comprising of lesser number of stocks. Besides, the investible universe of stocks is the same for sector funds and sectoral indices, and therefore, it becomes even more difficult to outperform. Although we don't have passive sector funds in this space yet, expect to see some action here.

Benchmark MF has filed offer documents with Sebi to launch exchange traded funds for nine sectors which will include sectors like pharma, cement, telecom and auto. This will give investors an exposure to passive sector funds.

Diversified equity funds can rotate their portfolio according to changes in corporate fundamentals and other determining factors. However, sector funds have to stick to their portfolio irrespective of whether that sector is doing well or not.

Sectors move in and out of favour with investors according to market grapevine and also sector performance. Sector funds have the potential to generate additional returns for your portfolio; but they tend to be volatile.

A retail investor could do well by allotting a major portion of your equity portfolio to diversified equity funds and only 15-20 per cent to sector and thematic funds. Too much of a seemingly good thing might not be good for your financial health.