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Thematic or sectoral funds are mutual funds that invest in a particular industry or sector or around a theme. Some of these funds are investing in sectors such as technology, banking and financial services, utilities, auto and auto ancillaries, real estate, and so on. They could also be following a particular theme like consumption and investing in consumer goods, healthcare, and financial services companies, among others.
According to the latest Securities and Exchange Board of India (Sebi) directives, a fund can be deemed as thematic or sectoral if it invests at least 80% of its assets in that sector or theme. These funds are considered high-risk investments as a majority of their investments are linked to a particular sector. Any adverse impact on the sector due to change in the macro or micro economy, changed business regulations or change in consumer behaviour or technology can in hit investments. In other generic funds, since the investments are diversified, any adverse impact to a particular sector can be nullified by positive news on other sector allocations. This diversification is not possible in sectoral or thematic funds.
That’s why, timing one’s entry and exit in these funds becomes quite important. The annualized returns for five-year periods for Franklin India Technology Fund that was launched in 1998 (at the peak of the tech boom), show a wide difference depending on the entry and exit timing. For instance, in the five-year period between 1998 and 2003, the fund gave 26% annualized returns, but between 2003 and 2008, another five-year period, it gave only 10%. However, timing the market is very difficult, especially for retail investors.
But there are advantages of investing in such funds. The two biggest advantages of a sectoral fund are that they allow investors to invest primarily in a sector that they are upbeat about or which they feel is at the bottom of its business cycle. These investments, if timed correctly, can lead to higher returns than diversified funds where the higher returns of investments in a specific sector can be offset by the lower or negative returns of the other sector allocations. Many investors use sectoral funds to invest in cyclical sectors which are at the bottom of their business cycles. For example auto sector is considered a cyclical sector. An astute and patient investor could invest in this sector through an auto sector fund to generate above-average returns and book profits at the peak of the cycle.
The same fund mentioned above has given an annual return of more than 18% since its inception. ₹1 lakh invested in this fund is now worth more than ₹33 lakh, which is a 33-time appreciation in 21 years. At the same time, this fund from its peak in March 2000 gave close to 10% annualized returns.
Since sectoral or thematic funds come with higher risks, investments in these must be done only on the advice of experts or if the investors are experts themselves in understanding stocks and stock markets. Some of the sectors are cyclical and hence understanding these cycles becomes important as well. These business cycles can be short or long, depending on the specific sector. As timing of these investments and redemption plays a very important role in the returns being generated by such funds, a lot more careful analysis and planning is required before investing. One can also adopt different strategies with these funds, some for long-term growth (sunrise sectors/themes), some for medium-term tactical gains (cyclical/beaten down sectors) and some for defensive strategies.
However, It is not recommend more than 15% allocation of your investments to these funds. This 15% could be divided among two-three sectors or themes. You must remember that your other mutual fund holdings may also have some allocation to these sectors. Making large allocations to these funds can be risky and should be avoided by retail investors.
Also, there are some sectors or themes that are coming in vogue or their business cycles are on their way up. These cycles can fully play out and reach their peaks in the medium term (three to five years) or can take even longer. Hence, not just knowledge of these cycles but also patience in allowing the cycles to fully play out is important. Retail investors should seek professional advice both at the time of entry and exit from these funds.
