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Among the list of top-performing funds over the past 10 and five years, technology funds are well-represented. ICICI Prudential Technology Fund ranks fifth among all equity funds when it comes to 10-year returns with a CAGR of 19.98% (as of 20 May). On a five-year basis, it is joined by Aditya Birla Sun Life Digital India. Tech funds continue to feature in mutual fund rankings in the past three years as well alongside pharma and healthcare funds.

With the rapid growth of passive investing, fund houses are expanding the options for investors to take these sector bets through exchange-traded funds (ETFs) rather than actively managed sector funds. Both ICICI Prudential Asset Management Company (AMC) and Axis AMC have launched healthcare ETFs in the past month. Large AMCs are increasingly covering three major sectors through ETFs—IT, healthcare and banking and there are plans to launch FMCG ETFs as well.

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Mint looks at whether investors who are planning to focus on particular sectors should use ETFs as a vehicle.

In April, sectoral and thematic funds saw the highest net inflows among all equity sub-categories at 1,705 crore. Investment professionals often seek to generate alpha (excess returns) for clients through sector funds.

“In October, I was keen on allocating more of my clients’ portfolios to metals and there was no sector fund available for it. I solved the issue by partnering with a fintech platform, but it was a cumbersome process," said Anand K. Rathi, founder partner, Augment Capital Services LLP.

A Sebi filing by ICICI Prudential AMC for a metals and energy fund of funds investing in the First Trust Strategic Metals and Energy UCITS Fund shows an industry rapidly waking up to this need. A Sebi circular in February 2019 provided a framework to mutual fund houses launching sector ETFs.

“As per Sebi rules, a sectoral index can have a maximum 35% weightage in a single stock and the portfolio must have a minimum of 10 stocks. This has provided clarity to both index providers and asset managers. In India, there are different kinds of investors and we think a section of them is likely to prefer the ETF route given its low costs and transparency. We launched a banking ETF in 2019, followed by an IT ETF and a private bank ETF. We are exploring an FMCG ETF as well," said Chintan Haria, head, product development and strategy, ICICI Prudential AMC.

The sharp rise in the number of direct stock investors who have demat and trading accounts have also made ETFs a more accessible vehicle. ETFs are purchased and sold on stock exchanges.

The number of new demat accounts opened during FY20 was the most in at least a decade at 4.9 million, a 22.5% increase from the 4 million accounts opened in the previous year. Total demat accounts at the end of FY20 stood at 40.8 million, up from 35.9 million on 31 March 2019.

To be sure, investors can directly invest in stocks that are part of a sector, but this is a cumbersome activity and requires active rebalancing of the portfolio as stocks change their weights in sectors. An ETF offers a ‘pre-packaged’ route to sector investing by including the stocks belonging to a sector like IT or pharma in proportion to their index weights. Some AMCs have exclusively taken the ETF route to individual sectors rather than active sector funds.

“We did not launch any sector funds since we didn’t think that was the right vehicle for investors. Our sector products are ETFs, which we think suit sophisticated investors who have a sector view. ETFs can efficiently capture sector returns," said Ashwin Patni, head, products and alternatives, Axis MF.

Axis MF launched a banking ETF, technology ETF and healthcare ETF in November, March and April, respectively.

Investing in sectors through ETFs rather than actively managed MFs has some obvious advantages. First, there is no exit load and hence you can take short-term positions in sectors through ETFs. Active funds typically have exit loads for short holding periods.

Second, you do not take the risk of the fund manager going wrong—you hold stocks in the sector in proportion to index weights. Actively managed funds in several categories have underperformed indices for several years, according to the SPIVA report published by S&P Dow Jones Indices.

Third, ETFs have lower expense ratios than actively managed funds, lowering the costs that investors face.

However, advisers are cautious about adopting this route. “I think there should be more sector funds, but actively managed funds. When you invest in a sector fund, you do so with a high return expectation, so cost should not be a big issue there," said Rathi.

Investing in sector funds is a concentrated bet on a few stocks. It is a risky proposition. “In general, I don’t recommend sector funds. If the client is determined to get into them, I don’t recommend investing more than 10-15% of one’s portfolio in them," said Kalpesh Ashar, founder, Full Circle Financial Planners and Advisors.

However, for sophisticated investors who do understand particular sectors, ETFs have given an additional route.

ETFs carry various risks—they can trade at steep premiums or discounts to the published net asset value of the ETF and liquidity in them can be poor.

The ETF trend is still nascent with the overwhelming majority of sector or thematic funds being actively managed and this may be keeping investment advisers cautious. “Given their high-risk nature, one should either pick an actively managed fund or a combination of actively managed and an ETF. I would not suggest an ETF-only approach to sector investing," Ashar said.

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