Diversified Equity Funds Vs. Sector Funds: which Is right for you?

When it comes to investing in mutual funds, there are numerous options. Even within equity mutual funds there are several categories and investment approaches.

While some equity funds diversify across sectors and market capitalisations, others focus on a single sector or theme. These are known as sectoral or thematic funds. Knowing the difference between these two broad approaches can help you make a suitable choice.

Let’s take a closer look at the differences between diversified equity funds and sector funds and how to choose between them.

• Table of contents

1. Understanding diversified equity funds
2. Understanding sector funds
3. Factors to consider when choosing between diversified funds and sector funds

Understanding diversified equity funds

A diversified equity fund is a type of mutual fund that invests in a wide variety of stocks from different industries and sectors. Such funds could follow a multi-cap, multi-sectoral and multi-theme approach. The goal is to reduce risk by spreading investments across different areas and sectors of the economy. If one sector does poorly, the loss might be offset by gains in another sector.

For example, a diversified equity fund may might invest in technology, healthcare, finance, as well as consumer goods. It may also include large cap, mid cap as well as small cap stocks. This approach seeks to mitigate risk, which could appeal to investors who want to combine the superior return potential of equities with risk mitigation measures.

Understanding sector funds

A sector fund, on the other hand, focuses on a specific sector or industry and aims to capitalise on its growth potential. For example, if you believe the technology sector will perform well, you might invest in a technology fund. Similarly, there are funds that focus on healthcare, infrastructure, pharmaceuticals, utilities, etc.

These funds can offer high returns if the sector performs well, but they also come with higher risks if the sector performs poorly. Investing in such funds also requires some degree of research or knowledge of sectors that are likely to witness significant growth over the investment horizon.

Factors to consider when choosing between diversified equity funds and sector funds

When choosing between a diversified equity fund and a sector fund, consider the following factors: Risk tolerance: If you can handle higher risk for the possibility of higher returns, a sector fund may be suitable. If you want to a better balance between risk mitigation and return potential, you may prefer a diversified equity fund.

Market knowledge: Investing in sector funds requires insight and knowledge of sectors that are likely to perform well. Moreover, the right sector would depend on the investment horizon. Some sectors may have growth spurts in the short term while some essential sectors may consistently perform well over a long horizon. However, if you want to align your investment’s performance with broader market trends, you may find a diversified equity fund to be more suitable.

Economic conditions: Consider the prevailing economic conditions. Diversified equity funds are generally better in uncertain economic times, while sector funds can perform well when a specific sector is booming.

Role in your portfolio: Sector funds can be a part of your portfolio that aims to generate market-beating return potential. However, for overall portfolio stability, it may be suitable to include diversified equity funds as well as hybrid or debt mutual funds.

Conclusion

Choosing between diversified equity funds and sector funds depends on your risk tolerance, investment goals, market knowledge, and economic conditions. Diversified equity funds offer a balanced approach between risk and reward potential, spreading risk across various companies, industries, and themes. Sector funds focus on one industry, offering higher potential returns in the right environment but with higher risks. Understanding these differences will help you make informed investment decisions that align with your financial goals.

FAQs

How do diversified equity funds and sector funds vary in terms of risk and return potential?
Diversified equity funds invest across various sectors. This mitigates risk, but could curb return potential. Sector funds focus on one sector, such as technology or infrastructure. This can lead to higher returns if the sector performs well but also entail higher risks because the fate of the portfolio hinges on one industry.

Are sector funds suitable for long-term investing, or are they more appropriate for short-term speculation?
Sector funds can be suitable for both, depending on the sector's performance and your investment strategy. A longer horizon may mitigate risk to some extent because it would cover more market cycles. A short investment horizon would only be suitable if the sector performs along expected lines in that period. This would also require market knowledge and accurate forecasting, which is a risky proposition.

Can sector funds outperform diversified equity funds during certain market conditions?
Yes, sector funds can outperform diversified equity funds when their specific sector is doing well. However, they also pose higher risks if the sector underperforms.

What are some common mistakes investors make when choosing between diversified equity funds and sector funds?
Common mistakes include not understanding the risks of sector funds, not diversifying enough, and not aligning their choice with their risk tolerance and investment goals.

How can investors mitigate risks associated with both diversified equity funds and sector funds?
Investors can mitigate risks by diversifying their portfolios, regularly reviewing their investments, and staying informed about market trends and economic conditions.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.