Find out more about sector and thematic funds

One of the prime reasons which have led to the soaring popularity of mutual funds in recent years is the variety and flexibility they afford to investors. Be it risk factors, investment durations, investment instruments or their characteristics, all investors can find something palatable.

Making the right choice can be tricky though and especially the information overload problem can make it difficult for investors to not give in to hype. A broad working knowledge of the various kinds of mutual funds lay the foundation for investors looking to make the most of out of mutual funds.

Sector and thematic funds are two such types of fund which are somewhat diametrically opposite to the popular diversified equity fund formats and as such are commonly misunderstood by those new to the investment arena. Here are a few things you should know about sector and thematic funds before you invest in them:

What are sectoral funds?

A wide variety of sectors like technology, pharma, infrastructure etc., are the building blocks of the Indian economy. A sector fund is an equity fund that allows you to invest in businesses that belong to the same industry or sector which means your money will only be exposed to a specific sector. The idea behind these investments is that certain sectors may perform very well in the medium to long term and investors can capitalize on such opportunities to generate high returns.

While generic equity mutual funds mobilize funds from investors in stocks of companies, sector funds invest money with a focus on one area of the market that have similar offerings of products and services. For instance, a pharma sectoral fund will have equities of Cipla, Dr Reddys and such companies that manufacture medicines, medical equipments etc.

In sector funds, the selection of companies does not depend on market capitalization – sector fund investments are spread across large-cap, mid-cap and small-cap equities provided they belong to the same sector. As per SEBI’s mandate, fund managers of sector funds need to invest at least 80 percent of the fund’s assets in equities of a chosen sector.

The advantage of investing in sector funds is that if a sector is performing exceptionally well, you may get a chance to book inflation-beating profits but that is contingent on investors being able to hit the bull’s eye when entering and exiting the market, especially if the investment is short-term. This is because sectors are cyclical in nature and they may not always be aligned with

What are thematic funds?

Thematic funds are open-ended equity funds wherein investments are made in accordance with a pre-decided theme. Thematic funds can have a broader scope than sector funds and the focus is on themes instead of a sector or industry. This means that thematic funds can invest in equities of different sectors as long as the theme is congruent. For instance, ESG funds are thematic funds in which investments are made in companies of different sectors that have a good track record in terms of environmental, social and corporate governance factors. In this case also, SEBI has laid down that the minimum investment in equities of a particular theme shall be 80 percent of the total assets.

Thematic funds offer more diversification than sectoral funds because investments can be made in stocks of companies in different sectors that fulfill the theme criteria. On the other hand, when you invest in a sector fund, your portfolio remains confined to that particular sector and should there be any downfall in that sector, the losses can become significantly high because of the concentration of stocks.

Things to keep in mind before investing in sector and thematic funds

• You should have a fair understanding of the fund’s objectives and whether it matches you’re your investment goals. Sector and thematic funds are better suited for investment horizons of more than five years owing to the high volatility quotient. Also, it takes a few years for a sector to grow to a certain level.

• The lesser the diversification, the greater the risk and this is what makes sector and thematic funds more suitable for investors who are comfortable taking high risks. Also, timing plays a crucial role here because the performance of these funds is connected with the economic cycle. Timing one’s entry and exit can be a challenge novice investors and inappropriate timing can lead to heavy losses.

• While thematic funds are more diversified than sectoral funds, both these classes of mutual funds carry higher risks due to lack of diversification than multi-cap mutual funds which invest in companies of various sectors. It is thus imperative to analyse the weightage of these funds in your portfolio so that you don’t end up taking higher risks.

Key Takeaways

• Before investing in sector or thematic funds, check the earnings of the sector and whether the theme is sustainable. There is no point plunging into these investments if the sector is not making progress or if the theme is just a fad.

• Estimate your expense ratio before investing. Asset Management Companies (AMCs) charge an annual fee for managing funds. This covers the fund’s operating and other expenses. It is better to avoid investing in funds where the expense ratio can eat into your returns.

This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.