FundsIndia Explains – Thematic and Sector funds

Most equity mutual funds invest across sectors and industries. But some funds choose to restrict this to certain segments. They are called thematic and sector funds. Though thematic and sector funds come across as more risky compared to your , diversified funds, they can add another arm to your portfolio in terms of investment avenues especially for those investors who are can afford to take that additional risk in their portfolio.
Let us look at what thematic and sector funds are, how their risks compare with diversified funds and whether they are suitable for you.

What are they?
Sector funds tend to take focused exposure to a single sector or related sectors. For example an IT, FMCG or a pharma fund will particularly be invested only in these sectors alone. Over 90% of ICICI Prudential Technology fund, is invested in the IT sector alone. Similarly SBI pharma fund has around 10% of its AUM in healthcare services while the rest 80-85% of the fund is invested in the pharma sector.

Thematic funds, on the other hand, invest in themes. This would typically be a host of sectors woven around a particular theme. For example infrastructure, manufacturing or MNC are all themes. Hence a thematic fund is more diversified than a sector fund.

Sector funds are viewed as being defensive or cyclical depending on the sectors they invest in. For example FMCG, consumer goods or pharma funds are typically considered defensive as they weather various economic phases well. But others such as banking or infrastructure remove with economic cycles and are considered cyclical.

But then timing the entry and exit of a sector or thematic fund becomes crucial and SIPs can only do so much to average. For example, no amount of averaging would have helped infrastructure in the prolonged downturn between 2008-14. Similarly, while an FMCG fund can weather down markets well, it may lag other sectors in a rallying market. Thematic funds, on the other hand, are less impacted and do not require too much of market timing and they are more diversified. For example: an MNC fund may hold stocks across defensive sectors such as pharma and FMCG or cyclical sectors such as capital goods and engineering. Similarly a broad theme like ‘Build India’ may weather falls better than pure infrastructure funds.

Risks
Among the various categories of funds, sector funds are the riskiest since these funds deviate from the basic premise that mutual funds are meant for the purpose of diversification.

In the event of a down turn in the sector, the fund manager has no option but to move into cash, and only to the extent of 35% to maintain equity taxation for the fund. In the case of a diversified fund, the manager not only has the option to move to cash at the event of a down turn, but also has the option to avoid an underperforming sector and invest in other other sectors as well. Though thematic funds are less riskier compared to sector funds, they still are not as diversified as a diversified fund as they still have restrictions on where they can invest. To this extent, they are riskier than diversified equity funds.

Who should invest?
Investors who know the sector/ theme well and know when to invest and exit should be the ones taking bets on sector/thematic funds. These funds are also for investors who would like to take concentrated bets on a particular sector or theme but are unable to decide which stocks to invest in. By buying such a fund, they buy the entire basket of stocks in that sector. In all, sector and thematic funds are meant for seasoned investors who have domain knowledge regarding a sector or theme and know when to enter or exit. Even if they fulfill this, they would do well to hold not more than 10-15% of their overall holdings in such funds. This is because, they would be getting exposure to those sector through diversified funds as well.