Are sector rotation funds the answer to risks of sector downturns?

These numbers reflect the rising investor interest in sectoral themes, with mutual funds catering to this need with a spate of new fund offers.

However, in the dynamic world of investing, one thing is constant – market sectors are never static. They rise and fall, driven by evolving macro-economic conditions, policy environment, consumption patterns and global trends.

For investors, these sectoral shifts can be a double-edged sword—while certain industries may thrive, others can face sudden downturns, leaving portfolios exposed to risk. Behavioural biases often drive investors to enter sectors when trends are favourable, but inertia can lead them to stay invested even as conditions change, ultimately affecting their returns. And if they happen to enter at the peak, they often get caught in sector traps with negative returns till the sector cycle reverses.

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As market dynamics continue to evolve, the need for a more adaptable investment strategy has become increasingly apparent. Sector rotation is one such investment strategy that represents a forward-thinking approach, enabling investors to diversify their portfolios across various sectors while actively reallocating assets in response to market trends. This flexibility not only helps mitigate the risks associated with sector-specific downturns but also positions investors to capitalise on emerging opportunities.

As Peter Lynch once said,“If you are in the right sector at the right time, you can make a lot of money very fast”.

The real challenge lies in not only identifying the right sector as it begins to trend upward but also timing the exit precisely when the cycle reverses and reallocating to the next best opportunity—a difficult feat even for the most seasoned investors.

Sector-Specific Risks

Sectors are seen as drivers to gross domestic product (GDP) growth, representing different parts of the economy such as technology, healthcare, finance, capital goods etc. Each sector responds uniquely to factors like interest rates, inflation, technological innovations, and geopolitical events. For example, rising interest rates may boost financial stocks while dampening growth in real estate or consumer goods. Similarly, technology stocks may soar during periods of innovation but fall when demand drivers slow down.

For investors heavily invested in one sector, the impact of these fluctuations can be severe. The infamous dot-com bubble and the 2008 financial crisis are stark reminders of how sector-specific downturns can erode wealth rapidly. This is where a multi-sector approach proves its value.

Strategic Portfolio Diversification

Multi-sector rotation fund aims to capitalise on the strength of diversified sectoral exposure, offering a strategic advantage by reducing dependency on the performance of any one sector and shielding from sector downturns.

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Actively managed, these funds continuously analyse market conditions and adjust sector allocations to maximise returns and mitigate risk. Factor based models supported by fundamental analysis can help get the timing right for both entry and exit. By rotating investments based on relative sector performance, the fund pivots as needed—for example, shifting from underperforming technology stocks to booming healthcare sectors. 

This fluidity gives multi-sector rotation fund a dynamic edge over traditional sector funds, which remain tied to a single industry regardless of its performance. By distributing assets across multiple sectors, these funds lower concentration risk, ensuring that a downturn in one sector does not lead to a significant decline in the overall portfolio. This approach balances risk and return, making it appealing for investors seeking both growth and protection.

Emerging evidence quoted in international research papers also suggests that sector rotation strategies may produce returns above the average benchmark, both during contractionary as well as expansionary monetary policy regimes.

These funds are also more tax efficient, since an individual investor is subject to capital gains tax if they were to buy or sell a fund or stocks, while there is no tax impact when the fund manager does so.

Hence multi-sector rotation fund may help future proof an investor’s portfolio providing an efficient option to individual sector funds, enabling asset allocation at a sector level while aiming to improve overall returns across economic cycles.

Kartik Jain is MD & CEO at Shriram AMC. Views are personal.