As we look at the 1-year returns when writing this story (September 24, 2012), SBI Magnum FMCG displays a fabulous 33%, ICICI Prudential Technology stands at 28% and SBI Magnum Pharma at 24%.

What's common amongst these three?
All are sector funds.

However alluring the returns appear, investing in such funds is very tricky. Investors tend to look at the latest performance and get influenced. That's a recipe for disaster. Getting into a sector needs you to look at the valuations, momentum going ahead, fundamentals of the sector as well as the business cycle. To invest on the assumption that the sector will continue to do well is naive and baseless. It could plummet and how would you feel about that?

ICICI Prudential Technology trounced the Nifty in 2009 but underperformed the index substantially in 2007 and 2008. In 2007, SBI Magnum Pharma delivered a measly 7% when the Nifty returned 55%. Take a look at the table to see that different sectors hog the limelight at different points in time.

Here are a few questions to keep in mind when picking a sector fund.

1) Why
Why do you want to invest in this sector?

Do you honestly believe in its fundamentals? For instance, an investor who is of the firm view that India is under banked and Banking is a proxy for growth in the Indian economy would do very well investing in such a sector fund.

An issue here is that a regular equity diversified fund in your portfolio may already have a huge exposure to Banking. But fund managers in a diversified fund keep rotating between sectors so you could still have a sector fund even if the current exposure in your diversified fund is high. On the other hand, if you find that your diversified fund, over very long periods of time, has held a consistently high exposure to Banking, then you can reconsider whether or not you really need that sector fund.

2) Which
Which fund should you invest in?

Within a particular sector, there may be a choice of funds. Take a good look at all of them. What sort of concentrated bets do they take? Does the fund manager gravitate towards a particular market cap? How does he define a sector? For instance, one fund manager may include NBFCs and financial institutions in the investment universe of a Banking fund. Another may stick purely to banks. Also consider their performance over the years with their peer group and benchmark.

3) How
How must you make your selection?

We are assuming that if you are considering a sector fund, you already have a base portfolio in place. Once you have the foundation in place, in terms of one or two equity diversified funds, only then consider a sector fund. A sector fund must complement your portfolio, not supplement it.

4) What
What is the fund all about? Is it a sector or thematic fund?

A thematic fund is a close cousin of the sector fund. By not limiting itself to a clear and specific identifiable sector, its investment mandate is a theme. So Banking and Pharma are specific sectors, while Real Estate and Infrastructure are themes. One such fund, ING Global Real Estate Retail is grabbing attention with a 30% annual return.

Thematic funds have more flexibility in the sense that the interpretation of the theme is left to the fund manager's discretion, while a sector is more tightly defined. But the principles involved in selecting both are fairly identical.

Years: Calendar years / Figures: Percentage (%) / Source: Accord Fintech

Fundsupermart.com