Sector, thematic funds: How to choose the best of the lot

Sector and thematic funds require solid entry and exit strategies

Sector and thematic mutual fund schemes are getting more popular by the day. Of all the equity-oriented and hybrid new fund offers (NFO) launched from January 1, 2023, to March 31, 2024, sector and thematic funds collected among the highest inflows, as per Value Research data.

Of the 10 largest funds in this lot by assets under management (AUM) as of March 31, five were thematic/sector funds, including the two largest: SBI Energy Opportunities Fund (Rs 7,454 crore) and SBI Dividend Yield Fund (Rs 6,935 crore), according to Value Research.

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However, in May, HDFC Manufacturing Fund, a thematic fund, collected close to Rs 10,000 crore in its NFO. As per the Association of Mutual Funds of India, there are 161 sector and thematic funds. Of them, 64 were launched since the start of 2020, showing how such funds have become popular. And distributors and financial advisors are taking note.

Here are four ways to profit from a sector/thematic fund.

Not meant for everyone

Experts said sector and thematic funds aren’t meant for everyone. These funds should be looked at from a satellite approach, as schemes that add flavour to your portfolio. That’s because such funds pin their hopes on a single or few sectors.

As per rules laid out by the Securities and Exchange Board of India, the capital market regulator, a sector or thematic fund must invest at least 80 percent of its corpus in the sector or theme it tracks.

“We only suggest sector and thematic funds to those investors who are able to carry the risk that these funds bring along - the risk being that these sector or themes may not play out as expected," said Srikanth Bhagavat, managing director of Hexagon Capital Advisors. "In which case, one has to contend with loss of expectations, disappointment and sometimes even loss of principal.”

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Also read: Confused about which mutual fund to invest in? Check out MC30; Moneycontrol's curated basket of 30 investment-worthy mutual funds

Bhagavat said his firm hadn’t been recommending sector and thematic funds all these years but started suggesting them, selectively, in the past two years.

Gajendra Kothari, managing director of Etica Wealth Pvt Ltd., a Mumbai-based wealth management firm, said that sector and thematic funds call for a different mindset from investors.

“Those who have patience, have control over their temperament and patience in their advisor can invest in sector and thematic funds,” said Kothari, because some calls go right, some might also go wrong.

Sector and thematic funds

Kothari has an interesting approach. Before recommending exotic, high-risk funds or those with newer ideas to clients, he invests his own money and tries them out first.

His early investments in sectors such as public sector undertakings (PSUs), transportation and most recently, China funds, have made money for him. Ever since - after being convinced about these sectors/themes - he has taken these funds to his clients.

In search of the best theme

A close reading of the economy and market is crucial to dig out diamonds in the dust. Ravi Kumar TV, director of Gaining Ground Investment Services, said his firm recommends thematic funds that have a strong growth potential in the long term.

“Consumption is one particular theme we think should be in every long-term investor’s portfolio,” he said.

In search for the best theme / sector fund

Harsha Upadhyaya, chief investment officer - equity and debt at Kotak Mahindra AMC, nudges investors to look for opportunities around them in their daily lives: from the morning cup of tea or coffee (consumption theme) and traveling to work in a car or public transport (manufacturing theme) to using the city’s roads and flyovers (infrastructure theme) and spending time at work (technology), Upadhyaya points to themes that surround us, make a difference to our lives and are easier to identify.

Earlier this week, Upadhyaya spoke about the merits of sector and thematic funds to MF distributors and investment advisors at a month-long seminar organised by NetworkFP, a platform that helps financial planners build their practice to educate them about different categories of mutual funds and how best to use them.

Over time, sectors and themes have evolved too, said Ravi Kumar TV. A banking and financial services fund doesn’t just include banks, it also has insurance, asset management, fintech, and housing finance companies.

“The recent thematic funds are no longer concentrated portfolios but broad market funds with many companies in that particular theme,” he said.

SIP or lumpsum

Although distributors and advisors typically suggest systematic investment plans (SIP) for investors, sector and thematic funds aren’t really bound by such thumb rules. When Kothari of Etica Wealth first invested in the PSU theme four years ago, he wasn’t sure how it would perform, which is why he decided to jump in with SIP. For the first three years, the PSU theme didn’t perform.

“If my investors had invested a lumpsum simultaneously at the same time I did, they’d have given up by now because their lumpsum would have gone nowhere. But then the theme did very well in its fourth year and the SIP investment paid off,” said Kothari.

Ravi Kumar TV, too, is flexible.

“Certain themes might have shorter durations due to various macro cycles. Lumpsum may be preferred here. SIP can be considered for long-term themes such as consumption, banking and financial services, healthcare, and technology," he said.

How much to allocate? Bhagavat said it’s important to ascertain how much exposure is needed in sector and thematic funds in order to mitigate risk.

“Not more than 10-20 percent of your overall portfolio should be invested in such funds. This ensures that even if the theme doesn’t work out, the broader portfolio doesn’t get impacted in a major way,” said Bhagavat, who has invested in the banking & financials and manufacturing themes.

How long to stay invested

A typical and across-the-board, long-term approach doesn’t always necessarily work. Upadhyaya of Kotak MF said timing the entry and exit is crucial in thematic and sector funds because different sectors have phases of outperformance and underperformance.

“When it comes to the timeframe of investment, we always prefer the longest possible timeframe," said Bhagavat. "But then we have to realise that markets move quicker than anticipated sometimes. Valuations reach their peak sooner than we expect. In which case, the timeframe become irrelevant. If themes and sectors at this point seem overvalued, then we exit. A sharper eye is needed.”

Ashish Chadha, a registered investment advisor in Gurugram, said themes such as transportation and infrastructure are high-beta funds - you need to a bit more active and exit at the right time. But fast-moving consumer goods, pharmaceuticals and banking are longer-term trends, he added.

Chadha has an interesting take on sector and theme funds. As an advisor, he recommends them to those who like to be a bit active with their portfolios.

“We make good money on sector funds for our clients. It also keeps them busy reading up. It prevents them from disturbing the bigger asset allocation and we can hold equity for 10-15 years and more without trading,” said Chadha.