These funds are considered one of the most dynamic, diversified, and flexible of all mutual funds. And rightly so, as they have the freedom to invest in stocks of companies that span across large, medium, and small market capitalisation. The restriction does not even apply to sectors.
Hence, the amount of risk distribution is significant and consequently, the ability to counter volatility as well. Due to this fluidity, the fund managers can use a sector rotation strategy to sell stocks in one sector and reinvest the proceeds in another as per the current stage in the economic cycle.
What is Sector Rotation?
As the name suggests, it is an investment strategy that involves shifting investments from one industrial sector to another depending on the stage of the economic cycle. This tactical method of allocation is grounded in identifying which sectors have the inherent potential to thrive during various stages of the economic cycle.
The Key to the success of this strategy lies in understanding the various economic phases the market goes through. In the early expansion phase, when the economy begins to recover, interest rates are low and inflation is controlled, major sectors to look out for are Banking, automobile, real estate, etc. The mid-expansion phase is marked by accelerated GDP growth and an increase in earnings.
Industries like infrastructure and information technology are expected to perform well under this scenario. Again, in the late expansion phase with soaring inflation and an overheated economy, focus should be on the energy sector and metal industries. The recession phase is characterised by high unemployment and slow growth, and it is time to lean on the Fast Moving Consumer Goods sector and healthcare.
Hence, it can be seen that there are two major categories of stocks. Cyclical stocks, which are impacted by the growth-recession cycle, and non-cyclical which are known for stable returns. Stocks belonging to the banking, automobile, and luxury goods industry move as per economic phases, whereas the healthcare and utility markets are usually known for consistent returns.
How do Flexi Cap Funds Apply Sector Rotation?
To simplify the process, fund managers initially track the macroeconomic indicators like GDP reports, inflation data, interest rates, IIP index, etc. The historical trends of different sectors are also studied to understand their responses to similar economic conditions. Sectoral performance indices like Nifty IT and Nifty banks can give an idea of the performance of specific sectors.
Then, a strategic decision is taken to readjust the portfolio towards sectors that are predicted to outperform in the coming economic cycle. In India, sectoral trends shifted with IT and Pharma industries leading during the post-COVID era, followed by rallies in banking, infrastructure, and energy. These shifts from 2020 to 2023 were driven by global energy dynamics, improvement in credit cycles, and rising healthcare needs.
In the mutual fund sector, funds like HDFC Flexicap Fund are known to dynamically allocate their corpus by following these market dynamics and keeping a track of these shifts in market scenarios.
Pros and Cons
Some major benefits of the Sector allocation strategy include:
- Risk diversification by diversifying portfolios which is the basic requirement for any investor.
- The profit potential is maximised by shifting funds to sectors that have the prospect to outperform in the upcoming market cycle.
- Since this runs on anticipation backed by historical data trends, it can be beneficial to both long-term and short-term investors if rightfully applied.
The downside of this strategy can be :
- Continuous monitoring and active market knowledge are essential to gain the full advantage of this investment strategy. Hence, it is not beginner-friendly unless there is guidance, support, and research backing.
- Transaction costs may be higher as it involves active buying and selling of the portfolio.
Conclusion
Sector rotation is an investment strategy that is inherent in flexicap funds due to the freedom they enjoy to take advantage of different phases of the economic cycle. It aids in smarter and informed decision-making by researching historical trends and being up to date about current events, which ultimately tends to increase the profit potential of your portfolio.
Spotting opportunities in various sectors like banking, infrastructure, FMCG, and Information Technology becomes easier, and you become ready for future shifts in the economy.
