What are sectoral and thematic funds?

Mutual fund investing is a vast concept comprising of different schemes suited for different investors. Amongst all the categories there are two schemes which are gaining popularity in recent times and these are sectoral and thematic funds. These funds are quite popular in mutual funds domain but not many of us know the difference between sectoral and thematic funds. There is a thin line of difference between these two as both belong to the category of equity mutual funds. Let us understand both the funds in detail.

Sectoral Funds: As the name suggests, sectoral funds invest in different sectors. They invest in sectors like pharma, banking, information technology, hospitality, construction, FMCG, real estate, etc. As per the SEBI guidelines, sectoral funds are supposed to invest a minimum of 80% of their assets in the specified sectors and remaining 20% can be invested in other debt or hybrid securities. These funds allow investors to take advantage by investing in best performing sectors.

What is it that drives investors to invest in sectoral funds?

Sector wise funds or sectoral funds provide a great opportunity to invest in the sector which is expected to give higher returns. Sectoral funds’ performance is directly linked with the performance of that sector in which the fund house has invested.

Let us understand it with a relatable example: After the outbreak of COVID-19, Pharma sector has become the point of attraction amongst investors worldwide. As per India Brand Equity Foundation (IBEF) report which came out in May 2020, India’s pharmaceutical sales went up by 9%. Pharmaceutical exports also grew to 16.28 billion dollars as on May 2020. These exports consist of Ayush and Herbal products as well. There is an upward trend going in pharma industry as government is continuously releasing funds to boost the health infrastructure. India is planning to set up INR ₹ 1 lakh crore (USD 1.3 billion) fund to provide boost to manufacture pharmaceutical ingredients domestically by 2023. Given the positive outlook of India’s pharmaceutical sector, it has become a lucrative sector to explore.

Downside: Since sectoral funds belong to equity mutual fund category, they carry a high degree of risk. Investors who are willing to take high risk can choose these types of funds. Investing majorly in a particular sector can be risky as most of the assets are locked in for at least 5 years and a sudden unfavorable moment can cause heavy losses. For example: Historically speaking, most fund houses tend to launch sector funds at the peak times. IT funds boomed at the peak of 2000 and later created huge losses for investors. On the similar lines the infrastructure-related sector funds launched their NFOs in 2007 and 2008. Investors should understand the patterns and remain cautious before investing in sector specific funds.

Thematic Funds: Thematic Funds invest in companies of various sectors having a common theme. Fund houses first define their theme and then look for companies who are following the same theme. It means that if investors are ESG conscious then they will invest in those companies which are rated highly on ESG parameters (Please click on the following link if you want to know more about ESG investing: https://sipfund.com/blog/What-is-ESG-Fund.html .

These ESG conscious companies could be in any sector unlike sectoral funds which focus only on one sector. Thematic Funds are more diversified than sectoral funds. Other themes could be rural development, trading, renewable energy, agriculture etc. Thematic funds are different from sectoral funds as the theme remains same across the sectors. As per SEBI guidelines, a thematic fund is supposed to invest 80% of assets in a specific theme and rest can be invested in different categories. Investors who are willing to take moderate risks can opt for thematic funds. Thematic funds are riskier than diversified equity funds. These funds require minimum of 5 years to give positive returns to investors.

What incentivizes investors to invest in thematic funds?

Industry body Association of Mutual Funds in India (AMFI) has mentioned that thematic funds are gaining popularity in current times as more and more Asset Management Companies (AMCs) are filing for thematic based mutual fund schemes. Recently Aditya Birla Sun Life Special Opportunities Fund and ICICI Prudential ESG Fund have collected around ₹ 1,800 crore by launching thematic schemes as per the AMFI data.

Investors who are risk takers and have long term horizon can opt for thematic funds. Fund managers are also actively looking for opportunities where they can take advantage from government schemes. For example: Most talked propaganda of recent government “Atmanirbhar” can be one of themes in near future.

Points to be noted before investing in thematic and sectoral funds

Track the past performances: Investors are recommended to have a look at the past trends before investing in sectoral and thematic funds.

Restrict the exposure: Savvy investors who are well-versed with financial markets can opt for sectoral and thematic funds. Having a diversified portfolio of regular funds is must before investing in sectoral and thematic funds. It is advisable to maintain balanced portfolio and invest 5-10% of your equity assets in sectoral and thematic funds.

Know your sector: Investors sometimes get carried away by one sector doing well that they start pouring money into that sector, but this is not what an intelligent investor should do. Rather, investors should do a thorough research about the sector in relation to its past performance, its returns and prospects. It is advisable to do an in-depth research of the sector while investing in sector specific funds. Sectoral funds are closely related to cycles of economy so charting out an exit strategy may help you if market goes haywire

Know the theme: It is equally important for investors to know about the theme’s prospects and its past returns. These are long term investments and investors should have patience to see their funds grow over a period of time. A thorough understanding of the theme is crucial before putting funds in thematic schemes. Mutual fund analysts can tell in advance about the themes therefore it is a decisive strategy to follow analysts’ report and look at the arguments provided for investing in particular theme and if that aligned with your goals then you should choose that theme.

Stop loss option:Experts believe that entering thematic and sectoral funds with a strict stop loss can prevent the investors from incurring huge losses. A stop loss of 15 – 20% can be set and if it goes beyond that then immediately exit the market.

Volatility: Many of the sectors have above-average volatility. For instance, materials, energy and information technology have a tendency of above-average volatility for the market. While they seem to be suitable sectors if you seek growth, they can also make you vulnerable to potential losses in the short term.

Cyclicality: Sector funds are cyclical in nature and dependent on the individual sector’s performance. Infrastructure sector did well in 2017, but the returns reduced drastically in 2018. Similarly, Banking stocks did well in 2017 but due to rising Non-Performing Assets (NPAs) and reported scams, they did not do well in 2018. Thematic funds are also cyclical in nature and can undergo long period of low returns. Thematic funds generally have a low correlation with the broader markets and hence, their performance can be in divergence with the broader market.

Summing up:Mutual funds are meant for diversifying the portfolio by minimizing risks, but sectoral and thematic funds go against this fundamental as they tie the fund in sectoral and thematic funds creating a concentration risk. Although these risks can be minimized if investors restrict their exposure within limits. Investors who have the capacity and willingness to take risks can opt for sectoral and thematic schemes since both are of cyclical nature. Thorough research and in-depth knowledge can be of great help while parking money in sectoral and thematic funds. It is suggested to keep your exposure within limits and not start taking bets on sky high expectations.

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