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Invest with care in infra funds as cyclicality can wipe out gains

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Thanks to the strong recovery in cyclical sectors, infrastructure funds delivered an average return of more than 70% over the past year, making them the second-best performing sectoral funds during the period.

Moreover, these funds have risen by an average of 30% since the start of the year. Infra funds gained due to recovery in cyclical sectors such as engineering and construction, cement, metals, and oil and gas, post the first wave of covid-19.

According to experts, with a markedly improved environment for creating infrastructure, both public and private, the infrastructure segment of the economy, and companies related to it, have the potential to grow faster than the real GDP growth.

“We feel the cyclical sectors are likely to do well over the next three-five years as the economic growth and earnings growth improve and become more broad-based. The government capex is improving, and the Union Budget gave a boost to the public sector capex. Residential investments in real estate are improving after a gap of five to seven years. We are seeing early signs of pick-up in the private sector capex also. We believe these sectors can perform very well over the next three to five years,” said George Heber Joseph, chief investment officer and chief executive officer, ITI Mutual Fund.

Some policy measures that have boosted the infra sector’s performance over the past year are the National Infrastructure Pipeline (NIP), where the government is planning to invest 111 trillion between FY20 and FY25, production-linked incentive (PLI) scheme, the Reserve Bank of India’s low-interest rate regime and lower corporate tax rates.

So, can infrastructure funds continue their performance going ahead?

According to experts, despite the strong one-year performance, the BSE Infra index is still below its January 2018 peak. Moreover, the index (on a historic basis) is trading at valuation multiples that are at almost 50% discount to that of Sensex both on the price to earnings (P/E) as well as price-to-book (P/B) basis.

“Therefore, this sector is offering an attractive investment opportunity over the next two to three years. It is important to not only evaluate the fundamental factors driving the future growth of different businesses participating in this segment but to also evaluate the valuations for the same,” said Amit Nigam, fund manager, Invesco Mutual Fund.

However, investors should keep in mind that investments in such funds do have the potential to earn superior returns, but are usually associated with higher volatility.

The two key reasons for the sharp fall of infra funds during downturns are higher earnings volatility of cyclical sectors and their higher leverage.

“As an optimum strategy, investors can deploy funds through systematic investment plans (SIPs), which can be supplemented with lump sum investments at times of drawdowns in the market. This strategy creates twin benefits of higher allocation to equity at better cost of acquisition,” said Nigam.

According to experts, as sectoral funds are riskier than diversified funds, the allocation should not be large in investors’ total equity portfolio.

“While leverage is not very high currently, earnings volatility, particularly in sectors such as metals, oil and gas and construction remain high. Hence, investors should have only a tactical allocation to sectoral funds,” said Joseph.

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