In 2007, equity mutual funds that were invested in infrastructure and related sectors gave the best returns; majority of the top 10 funds were invested in these sectors. Portfolios with a pre-dominance of these funds have done very well in the last year or two.

On the other hand, during the same period, funds dedicated to technology and auto gave negative returns. What are these funds that show such a wide range of returns and in which investors show so much interest? This category of funds is called sector funds.

What are they? Sector funds invest in a particular industry or sector to benefit from its growth. They are, however, more risky as their fortunes hinge on the performance of the particular sector. They tend to rise more than the broader market, but fall faster and deeper, too.

For instance, in the last six months returns from several funds invested in the infrastructure and related sectors, which have given high returns in the last couple of years, fell by over 20 per cent. The rationale: an upward cycle in the stockmarket is generally driven by specific industries, and investors will get undiluted benefits from sector funds in these areas as compared to returns from a diversified fund which may have exposure to sectors not performing as well.

History of change. Sector funds started in India in the late 1990s, initially encouraged by the Internet boom. The Internet bust saw the value of technology funds fall drastically. This, along with the lacklustre performance of the other sector funds and the limited choices available in them, soured investors, and relegated such funds to among the least-preferred choices.

Three years ago, these funds reinvented themselves by one, renaming themselves thematic funds and, two, broadening their investment mandate to include a wider group of related industries. This diversified the portfolio, which reduced risk, therefore, made the funds more attractive to a wider audience.

Infrastructure, energy, brand value, financial services and agriculture were some of the popular themes. The renewed interest in thematic funds has been justified by the returns from themes such as infrastructure, power and banking in the last few years.

So, is this reason enough for you to have sector/thematic funds in your portfolio?

Investor strategies

Sector funds should be looked at from a mid-term perspective. Returns from sector funds show that while they have topped the diversified equity funds chart in the 1-3 year periods, diversified equity funds score better over longer periods.

For example, funds in the FMCG, pharma and IT sectors with a five-year track record have given returns 15-20 per cent lower than those of diversified funds. If you want to invest for the long term, look at sectors that are down in the market cycle and whose stocks have attractive valuations. Investing at this point will mean high returns when the sector turns around.

Add variety. The strategy looks at diversified equity funds as the core of a portfolio and sector funds as the add-ons that increase returns. All investors can follow this strategy. Investors can temporarily tilt their portfolio towards the sector that they believe will do well. While this can be done with individual stocks as well, a sector fund reduces company-specific risks.

This tactical over-weighing will not alter the overall financial plan, but will enhance returns if the investor is able to enter and exit at the right time. Financial planner Lovaii Navlakhi says: "Our advice is that only incremental money should be invested into such funds. Also, the overall allocation to various schemes should be kept in mind to ensure that exposure to a particular industry from both diversified funds and sector funds is not too high."

Diversify. Here, the investor creates a customised diversified portfolio. This strategy is suitable only for active risk-taking investors and for those who want to take their own investment calls. Investors can allocate resources to various sectors either by following the weightages in various indices or according to their own preferences.

It requires active and informed participation in tracking sectors and rebalancing the portfolio. The drawback of this strategy is the absence of schemes that adequately cover all sectors, which makes diversification difficult.High risk, high returns.

The riskiest strategy is where the investor creates a portfolio of funds of only those sectors that are expected to do well without looking at diversification. This is an aggressive strategy and should be followed only by those willing to take a high degree of risk since it goes against the basic tenet of mutual fund investing - diversification.

Who should, and why

Thematic or sector funds are for investors who have a diversified portfolio and are willing to allocate a small portion for better returns. Such investors should actively manage their portfolios, track sector performance and take decisions on entry and exit. They must be willing to take some volatility in the returns.

Sector funds are suitable for investors who have knowledge about a sector, which, they are convinced, will do well in the future, and are willing to wait for it.

These funds can be used to increase returns in various ways depending upon the investor's ability to take risk. The best way is to add them in small doses to the portfolio to benefit from an upturn in a particular sector. They should not be looked on as complete investment solutions. Unlike diversified equity funds, these are high-maintenance funds that require investors to keep a close watch on the performance of the relevant sector and exit when momentum flags.

Other than enhancing returns, thematic funds also play the role of a hedge in a portfolio as there are some sectors, such as FMCG, which are considered as defensive sectors and can be used to tone down the fall in overall markets.

The impact of loads and taxes should also be considered when entering and exiting funds. These funds can lift the returns of a portfolio from ordinary to high, but should be used with discretion as the fall to earth can be swift and hard.