Sector and thematic funds: Exotic but niche

By - Hemant Rustagi

CEO, Wiseinvest Advisors

Sector funds, as the name suggests, invest in particular sectors. The basic idea of a sector fund is to enable investors to take advantage of industry cycles. Thus, they have the potential to offer attractive returns if the timing is right. However, they do not provide the downside risk protection available in diversified funds.

Thematic funds look for trends that are likely to result in the out-performance of certain sectors or companies. In other words, the key factors for these funds are those that can make a difference to business profitability and market values. Thematic funds focus on structural as well as cyclical factors that play an important role in the economy.

Who should invest in these funds?

Sector funds can be an ideal option for investors who understand a sector as well as its future potential, and seek diversification within that sector. Besides, these funds can play a supporting role in a diversified portfolio by allowing investors to increase exposure to sectors that may be under-represented in their portfolio.

For those who invest in stocks directly, sector funds offer advantages over individual stocks, as the fund manager tracks the industry/sector developments for investors. Since the performance of sector funds fluctuates depending on how the respective sectors/industries are performing in the market, a wrong selection of sector/s can adversely impact the overall portfolio returns. Therefore, it is essential for a sector fund investor to have the ability to withstand short-term fluctuations in order to enhance long-term returns.

Like sector funds, thematic funds also carry a high degree of risk. Hence, only investors who have experience of investing in equity and equity funds and have a high risk appetite should invest in these funds.

What should the strategy for investing in these funds be?

Broadly speaking, sector and thematic funds should constitute only a limited portion of an investor’s portfolio. Hence, only those investors who already have a well-diversified portfolio and who have the risk appetite to absorb extreme volatility should consider investing in these funds.

Individuals can adopt different strategies to reduce the risks generally associated with such funds. One such strategy is to have limited exposure to three-four sectors/themes. It is also advisable to review your portfolio to ensure that you are not investing in a sector/theme that you already have a sizeable exposure to through other funds.

Before investing in these aggressive funds, though, you need to assess certain key criteria that may be important to your profile. These are:

• How diversified is your existing portfolio?
• Do you have an appetite for risk and the temperament to tackle the volatile nature of sector funds?
• Do you have the capacity to hold these funds for the longer term if required, and can you curb the urge to switch from one sector/theme to another?

How much exposure should one have in sector/thematic funds?

As a thumb rule, for an individual who has decent exposure to equity funds and is conversant with the behaviour of the equity market, around 10-15 per cent of the portfolio can be invested in sector and thematic funds. Remember, while these funds can be riskier than diversified funds, they also have the potential to provide better returns. The key is to select funds carefully and monitor their progress over the investment period.

What are the risks involved in thematic fund investing?

On the flip side, there is always the risk that the market may take a longer time to recognise the views of the fund house with regard to a particular theme that forms the basis of a fund.

Besides, there can be ambiguity in a fund’s definition of a theme. For example, some of the infra funds have a low percentage of exposure to the core infra sector and their portfolios have exposure to more sectors than even a well-diversified equity fund. There is also the risk of a fund manager’s style becoming too individualistic, which may be difficult to follow if the manager decides to leave the fund.