When we look for diversification within equities, the first thing that comes into mind perhaps is Index funds. They provide a great diversification opportunity by default without betting on specific stocks. There is always a higher chance of a particular stock going bust, but the index always lives forever. Periodic stock rotation also ensures the dead weights are purged and new stars join the club.
One problem with the index is the fixed allocation percentages for stocks. For example, NIFTY50 is heavily skewed on Financial stocks (reference), and understandably so, since those stocks form the pillar of the economy. But with this, comes the risk of some sector laggards keeping the index progress in check.
Consider this, NIFTY50 has grown by 120% in the last 5 years, whereas NIFTYBANK has underperformed by growing by 75% in the same duration. All this is made worse when we see that Financial Services occupy 30-35% of the NIFTY weight. This essentially means other sectors have been pulling the weight of the price movement for half a decade. The intention is not to say that Financial stocks are bad, but to identify and bet on growth sectors as we see patterns.
If you go to any financial website, they will give a default disclaimer that Sectoral investing has high risk. To me, risk comes because of 2 facts –
- Sector performances are cyclical. So you do not understand the valuation and are over-investing at the peak, there is always a correction in offing.
- A concentrated portfolio in general indicates lesser diversification. So they are more prone to news-based market movements.
So should we bet on the “risky” investment subclass? I believe there is a significant opportunity loss in not tapping into these specific sectors in growth motion. Here are a few strategies I try to employ –
Observe rolling returns on the sector funds
Since many sectors are cyclical, check the rolling returns YoY. You can check this information from advisorkhoj.com tool. Here is a tech sector YoY pattern:
The reason for selecting a 1-year rolling window is to observe the stage of the cycle. If we take a a longer rolling window, the curve smoothens out (since in the longer run we expect the CAGR returns to be on expected lines), which then becomes less visible to mark the cycles. For the same fund as above, the following curve is for a larger rolling window.
So what the tech fund cycle gives some indication is that the sector is in uptrend again after the 2021 trough.
Keeping an eye on Sector PE versus Earnings
Going to https://www.moneycontrol.com/markets/sector-analysis/ provides a bird’s eye view of how the valuation looks at the sector level. From the below snapshot, it is evident that the Banking sector is undervalued, not just because of the current PE, but because the high YoY earnings growth just does not justify such a low valuation. So there is a more chance of price catch-up compared to Auto/Ancillaries at this point.
Diversifying to avoid bad quarter results
India’s IT sector has been a great example of this pattern. Even though the sector overall could be showing promising signs, certain bad quarters are popping up on specific stocks. That makes it extremely difficult to make your bets. In such a scenario, a broader sector fund bet helps ride the momentum in that sector while avoiding over-investment on bad bets. A good way to explore this is to check the relative performance, technicals, and ratios across stocks within a sector such as here.
A bad quarter also shoots up the PE of the stock since the earnings are not able to catch up with the current Price point. So diversifying helps avoid a sharper portfolio value correction.
Exposure to mid-caps and small-caps with lesser concentrated risk
Sector funds get the best of both worlds of being able to focus on a sector while diversifying into small-caps and mid-caps if you do not have a strong conviction on a particular stock. A lot of smaller companies ride the rally of sectors even when their underlying fundamentals may not be as strong as their bigger counterparts. Leaving it to fund managers here to manage that decision would be a better alternative.
To give one sample data, infrastructure sector has been booming over last few years due to increased budgetary allocation. So it is quite evident the sectorial funds have easily outperformed (source) the broader diversified funds.
My personal fund allocation has proportions allocated to sector funds. Below is a current dated pie chart of various diversification. To achieve risk reward balance, I generally keep an individual sector specific allocation to 5-10% at maximum.
This post was all about looking for time pockets to boost your returns in the mid-term horizon. Sector analysis requires being vigilant on both buy and sell points by following the sector valuation and return curves. Allocating a specific portion of your portfolio on this sub-form of equity diversification could play well to give your portfolio gains an added boost.
