Skip to main content
texts

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

#
sector fund
Share :

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 mutual funds India 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. How Does a Diversified Equity Mutual Fund Work?
  3. Benefits of a Diversified Equity Mutual Fund
  4. Understanding sector funds
  5. How Does a Sector Mutual Fund Work?
  6. Benefits of a Sector Fund
  7. 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.

How does a diversified equity mutual fund work?

A diversified equity fund allocates capital across multiple sectors and industries. By spreading investments across various segments, these funds mitigate risk and capture growth opportunities.

For example, a diversified equity fund can invest in sectors ranging from information technology to infrastructure. This approach provides investors with exposure to companies of different sizes and market capitalizations. The fund manager aims for a balanced investment across the economic spectrum, reducing vulnerability to sector-specific fluctuations.

Benefits of a diversified equity mutual fund

1. Protection during market changes

Diversified funds spread your investment across different industries and company sizes. This approach helps protect your investments when the market fluctuates. If one sector struggles, others might perform better, reducing your overall risk.

2. Supporting long-term financial goals

These funds are great for achieving big financial dreams like:

  • Saving for retirement
  • Funding your children's education
  • Preparing for major life events

By investing consistently over time, you can benefit from the power of compounding, which helps your money grow steadily.

3. Less time managing investments

With diversified funds, you don't need to constantly watch your investments. Professional fund managers handle the complex work of selecting and balancing investments. You can invest through:

  • Systematic Investment Plans (SIP)
  • Lumpsum investments

4. Learning different investment strategies

Diversified funds let you explore various investment approaches without being an expert. You can:

  • Invest across different company sizes
  • Try different investment styles like value or growth investing
  • Understand market dynamics without managing everything yourself

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.

How does a sector mutual fund work?

A sector mutual fund focuses on companies within a specific sector, instead of spreading investments across the entire market.

They invest exclusively in companies that operate in a single sector. A sector can include multiple related businesses that offer similar products or services. Examples might include technology, healthcare, energy, or financial services

Potential Benefits:

  • Opportunity to invest deeply in an industry you believe has strong growth potential
  • Possibility of relatively higher returns if the chosen sector performs well
  • Provides some internal diversification through multiple company holdings within the sector

Important risks to consider:

  • Highly concentrated investment approach
  • More volatile compared to broader market funds
  • Vulnerable to industry-specific economic challenges

Key Limitation: If the chosen sector experiences a downturn, the entire fund's performance will be negatively impacted. Unlike diversified funds that can balance poor performance in one area with stronger performance in another, sector funds lack this protective mechanism.

Benefits of a Sector Fund

Sector funds offer unique investment opportunities for those looking to capitalize on specific industry growth. Here are the key advantages:

1. Potential for high returns

When a particular industry shows strong growth prospects, sector funds can provide a suitable opportunity to benefit from that potential. By concentrating investments in a promising sector, investors can:

  • Target industries with significant growth potential
  • Capitalize on emerging economic trends
  • Potentially achieve relatively higher returns compared to broader market investments

2. Hedge against inflation

Some sector funds can perform well even during challenging economic conditions.

Certain industries may:

  • Operate independently of broader economic cycles
  • Provide returns that outpace inflation
  • Offer a strategic way to mitigate impact on investment during economic fluctuations

3. Sector funds are suited for investors who:

  • Have a good understanding of specific industries
  • Can tolerate higher investment risk
  • Are looking to complement their existing investment portfolio

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. If you're planning a Systematic Investment Plan (SIP) in either of these types of funds, you can take the help of an MF SIP calculator to fine-tune your strategy. The tool helps you see the potential returns on your investment based on your monthly SIP amount, tenure and expected returns. You can also adjust your inputs till you arrive at a investment amount or tenure that suits your requirements.

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.

texts