“By tracking the Nifty Chemical Index, the ETF provides exposure to a basket of leading chemical companies, mitigating single-stock risks and capturing the sector’s broad-based growth potential,” says Devender Singhal, fund manager, Kotak Mutual Fund.
Several other narrow-mandate ETFs track sectors such as real estate, auto, capital markets, and railway public sector undertakings (PSUs). “Funds with narrow sectoral mandates aim to capture cyclical tailwinds and turnaround opportunities while focusing on a relatively limited universe of listed companies operating within a specific sector,” says Nirav R Karkera, head of research, Fisdom.
Potential for outsized gains
Narrow sectoral funds can deliver strong returns if the sector experiences a favourable cycle. “A narrow sectoral fund has the potential to deliver superior returns when the chosen sector enters a growth phase. Such funds allow investors to take tactical exposure to capture opportunities arising from structural or cyclical trends within a specific industry,” says S Sridharan, founder and chief executive officer, Wallet Wealth.
These ETFs also provide a route for taking a contra view on sectors that are currently out of favour. Being passively managed, they do not carry fund manager risk and have relatively low fees.
The concentrated nature of these funds, however, amplifies both volatility and downside risk. “The risks attached to this strategy are higher volatility due to single-sector exposure, concentration risk, and lack of diversification. One should have a deep understanding of the chosen sector and carefully consider the market cycle before taking exposure,” says Singhal.
Multiple other risks exist. “Narrow sectoral funds are exposed to cyclicality, regulatory changes, valuation excesses, and liquidity constraints. Certain sectors may witness prolonged periods of underperformance depending on economic or policy cycles, which can significantly impact overall returns,” says Sridharan.
While ETFs typically invest in larger, liquid stocks, sectoral performance is often driven by a handful of stronger players. Investors may miss the best performers within the sector.
Returns from narrow sectoral ETFs depend heavily on the investor getting both entry and exit right. “Timing risk remains one of the key challenges. The most common and costly mistakes often stem from entering closer to the top of a cycle and exiting near the bottom, converting notional losses into realised ones. Simply trying to play short bursts of performance through excessive rebalancing and sector rotation may have a depreciating effect on the internal rate of return (IRR) owing to leakages on account of costs, including taxes,” says Karkera.
These products are best suited for experienced investors. “Investors with a deep understanding of market cycles, who know the nuances of a particular sector, have a high risk appetite, and are willing to accept high volatility are typically the target audience,” says Singhal.
“First-time or conservative investors should avoid narrow sectoral funds. Exposure to narrow sectoral funds should be limited to a maximum of 10 per cent of the overall equity portfolio with a minimum investment horizon of five years to navigate sectoral cycles and realise potential gains. Prefer a staggered or SIP approach to manage timing risk effectively, as accurately predicting sectoral turning points is inherently difficult,” says Sridharan.
Karkera suggests that investors take exposure to sectoral ETFs within the satellite portion of their equity portfolio.
The writer is a Gurugram-based independent journalist.
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