What are Thematic Mutual Funds and Sectoral Mutual Funds?

Over a period of years, quite an array of mutual funds have floated in the market. Among those, sectoral and thematic mutual funds have particularly caught attention these days. While both are indeed very similar by nature, however, the approach of each one of these mutual funds is remarkably different from the other.

But should you invest in them? Let's understand sectoral and thematic mutual funds, their advantages, risks, and whether or not they work as the best investment option for you.

Understanding Sectoral and Thematic Mutual Funds

Let's quickly understand what the sectoral fund and thematic mutual fund are first.

Sectoral Funds

• Investment focus on a specific sector of the economy (banking, pharmaceuticals, technology, or energy).

• Investments may take 70% to 100% of the assets of the fund in that specific sector chosen depending on market conditions and fund strategy.

• Sectoral funds can be suitable for those investors having an opinion that is strong enough regarding the potential growth of one particular sector.

Thematic Funds

• Invest in companies that share a common theme. The theme could be based across multiple sectors ("Digital India" theme).

• The portfolio allocation can range from 30-70% in one sector, with the remaining spread across other sectors contributing to the theme.

Ideal for investors looking to invest in broader trends or themes.

Both are very high-risk and high-reward investments. Though clearly dissimilar from sector to sector, thematic funds encompass a much more vast area than any other sectoral fund, again from a central theme.

Comparison: Sectoral vs. Thematic Mutual Funds

Advantages of Investing in Sectoral and Thematic Funds

1. High Returns: A Key Advantage of Sectoral and Thematic Funds

Sectoral and thematic funds offer exceptionally high returns, making them an attractive investment option. Since these funds are focused on specific sectors or themes, they can generate substantial gains if the relevant sector or theme performs well.

In the past decade, some sectoral and thematic funds have delivered impressive returns:

Thematic and sectoral mutual funds give an opportunity to an investor to bet on market trends and sectors. Here are some recent performance overviews:

Thematic Funds:

According to ICRA Analytics, the compound annualized returns for thematic funds are as follows:

1. 1-year: 46.06%

2. 3-year: 21.29%

3. 5-year: 24.07%

4. 7-year: 16.85%

Similarly, sectoral funds have reported the following returns:

1. 1-year: 44.66%

2. 3-year: 20.53%

3. 5-year: 24.77%

4. 7-year: 16.95%

Needless to say that such funds bring high return at the cost of high risk due to concentration. A particular investment must pass on the criteria of risk and aim before money goes into these types of funds.

Please note that past returns are not a guarantee of future performance. However, sectoral and thematic funds can be a great way to tap into emerging trends and growth opportunities.

2. Targeted Exposure:

These funds enable you to invest in specific sectors or themes that you might believe in. Suppose you feel that a certain sector, for example, the healthcare or renewable energy sector, will see growth in the coming years. In that case, sectoral funds provide you with an avenue to target that particular area of growth.

Similarly, if themes are emerging as electric vehicles or artificial intelligence, thematic funds also allow an investor to invest in those growth themes.

Diversification Within a Thematic or Sector Funds

Even though the sectoral and thematic funds emphasize a theme or particular sector, they still make investments in diversified companies within the sector or theme. The same example of the healthcare fund would have investments in pharmaceutical companies, hospitals, diagnostic labs, and biotechnology firms, where you end up getting diversification of the sub-sectors of the healthcare industry.

Risks of Sectoral and Thematic Funds

• High Volatility : Another significant risk associated with sectoral and thematic funds is their volatility. Since these funds focus on a given sector or theme, they tend to be quite responsive to the market fluctuations that happen in that sector or theme. Assuming you invested in a sectoral fund that has solely banking stocks, then during times of economic downturn or changes in regulation affecting the banks, your investment will also take a hit.
  The thematic funds also are volatile. If the theme, say electric vehicles does not perform well, the thematic fund will not do well.

• Lack of Diversification : While sectoral and thematic funds do bring in some diversification with their focused areas, they lack broader diversification found with other mutual fund categories like large-cap or multi-cap funds. Because these funds are focus-based, this may not provide portfolio protection that comes from a more diversified product.
  Sectoral and thematic funds often end up being very concentrated in a few stocks within its sector or theme. For instance, a technology-focused fund may have a large concentration of its investments in just three major technology companies. Such a focus may yield strong returns if those companies do well, but they incur the risk of heavy loss if those companies fail.

• Not Suitable for Short-Term : Sectoral and thematic funds are not very suitable for short-term investments because their returns may be quite volatile in the short term. The funds are more cyclically sensitive and might be performing only for a short period. A real estate sector fund may give excellent returns when the real estate market is booming, but it will severely suffer when the real estate market is getting corrected.

Should You Invest in Sectoral and Thematic Funds?

1. Your Risk Appetite : Sectoral and thematic funds are well-suited to those with high risk appetites. If you're looking for stability, then you are not likely the best match for them. Still, if you are prepared to take a higher risk for greater returns, then sectoral and thematic funds will be all right.

2. Market Timing : This investment in sectoral and thematic funds is all about good timing because the specific theme or sector fund focuses on a particular area and is susceptible to market cycles. To illustrate, sectoral fund related to infrastructural sectors might present a good bet during a government expenditure implementation period but will suffer during an economically unfavourable period.
   Hence, good knowledge of trends in the market shall be required to invest in such funds.

3. Diversification : It is always advisable to diversify your portfolio. Sectoral and thematic funds are good investment avenues that offer high returns, but they should not be your only investment. You should blend them with other more diversified funds to balance the risk.

4. Investment Horizon : Unless you have an opinion regarding the future growth of the sector or theme that you are investing in, sectoral or thematic funds would not be a long-term strategy. You might need to keep frequent track of these funds, and your investment will have to change to adjust to the market fluctuation.

Conclusion

Though sectoral or thematic mutual funds are very attractive propositions for investors who are targeting specific sectors or themes that have high investment potential, these too come with heavy risks such as increased volatility, lack of diversity, and overconcentration in a very few stocks.

Before investing in these funds, one should assess their risk tolerance and market knowledge in conjunction with investment horizon to ensure harmonious allocation. Sectoral or thematic funds are also recommended to be diversified with other types of mutual funds so that the risk is spread.

The returns are good if one is investing in sectoral and thematic funds, but a serious amount of research, risk-taking ability, and long-term investment are prerequisites. As usual, consult your financial advisor before taking any decision about investment.