Sectoral funds can have downsides; investors who want to play it safe can do better with diversified equity funds
For a long time, India’s information technology (IT) sector has been a key driver of the country’s economy, and the segment got a further leg-up after the covid-19 pandemic broke out last March.
In terms of sectoral returns, IT has been an outperformer by a wide margin. Over the past year, tech funds have delivered an average return of around 90% against 73% given by the next best sectoral fund—infrastructure. The outperformance can be seen even on a three-, five- and 10-year basis (see graph).
Moreover, the tech sector has continued to scale new heights, as its weightage increased to 11.7% (up 70 basis points or bps on a sequential basis and 350bps on a yearly basis) in overall equity funds, as of June-end.
The sector was second only to private banks (at 17.2%) in terms of allocation by equity funds, showed a recent report by Motilal Oswal Financial Services Ltd (MOFSL).
In June, three of the top five stocks that saw the maximum increase in inflows from the equity funds were from the technology space—Infosys Ltd ( ₹8,270 crore), Tata Consultancy Services Ltd ( ₹3,270 crore) and Tech Mahindra Ltd ( ₹1,580 crore), MOFSL’s note said.
“There were many domestic and global players who put technology to use in a much better and more inclusive way. Many of these companies started to boom during the pandemic. Going ahead, I see huge scope as technology will increasingly play a very important role in our day to day lives," said Rushabh Desai, a Mumbai-based mutual fund distributor.
IT mutual funds have given outstanding returns in recent years. But do they have the potential to continue doing so in the future? Let’s find out.
The Indian IT services industry has seen significant traction recently, aided by the increased criticality of technology at large enterprises. According to a recent report by MOFSL, the technology sector is trading at a price-to-earnings (P/E) ratio of 26.5 times, a 53% premium to its historical average of 17.3 times. Still, the sector remains attractive from a medium- to long-term perspective.
“We continue to remain positive on the sector, seeing it at the cusp of the unprecedented demand environment, triggered by compressed digital transformation," said PhillipCapital (India) Pvt. Ltd in a note.
Another brokerage, HDFC Securities Ltd, added: “Strong deal momentum (pipeline and large deal bookings), broad-based industry-vertical trends towards digital transformation, positive cyclical indicators in product development or engineering services and consulting, accelerated hiring, and improving alignment with hyperscalers/SaaS (software-as-a-service) indicate continuity of mom-entum for the sector."
While experts are largely bullish on the IT sector, there are some concerns as well. Led by the rally over the past few months, the valuations of mid-cap IT companies have become more expensive vis-à-vis those of their large-cap peers.
Kirtan Shah, chief financial planner at Sykes and Ray Equities (I) Ltd, who is bullish on large-cap IT stocks, feels the mid-cap IT space is highly valued now. “I don’t see a lot of room for improvement or a lot of upsides in terms of valuations," he said.
In a sector such as IT, investors should keep in mind that there might be pockets of outperformance and underperformance.
Desai, who is very bullish on the IT sector from a 10-15 year plus perspective, said lump sum investors need a bit of timing even while venturing into this sector. “If an investor puts in money, especially when the sector is undervalued, or the segment has seen a decent correction, he or she can sit on it for a good amount of time and maximize upside returns," he added.
Since the sector is commanding higher valuations and the returns have already come up quite strongly, a better strategy would be to do systematic investment plans for 10-15 years, while awaiting correction, for a lump sum investment in the sector.
Investors can consider global technology players for better diversification for their satellite portfolios. “Indian IT is still emerging. Currently, I would bet on the passive strategy, whether in Nasdaq 100 Index or NYSE FAANG plus Index stocks," said Desai.
Meanwhile, while investing domestically, investing in flexicap funds can be a smart strategy as most such funds are holding large-cap IT names against mid-cap IT names today. “Retail investors who are not sure of why or what they are buying would be always better off in a blended fund than a thematic fund. A thematic fund is for someone who really understands investing, can time sectoral rotation, and understand the risks involved. Thematic, ideally, is for sophisticated, and not retail investors," Shah added.
Suresh Sadagopan, founder, Ladder7 Financial Advisories, and a Sebi-registered investment adviser agrees.
“There is always a sectoral rotation in terms of performance. The philosophy must be to go for diversified equity funds rather than IT funds. But, as IT will remain very critical, one can have a small 10% sectoral allocation in the overall equity portfolio," he said.
Information technology funds are expected to continue their fine form, but investors should note that sectoral funds are risky. These funds can do very well in certain periods, but they can have downsides, too, and those investors who want to play it safe may be better off with diversified equity funds.