Do thematic funds fit into your mutual fund portfolio?

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The terms Thematic and Sectoral are often used loosely and interchangeably. But there is a difference between the two when it comes to mutual funds.

Sectoral vs Thematic Fund

A Sectoral fund invests in a single sector (automobiles, pharmaceuticals and soon) while a Thematic fund invests around a broad theme that cuts across sectors. An example of a thematic fund is an Infrastructure fund that invests in capital goods, construction, mining, energy and communication stocks.

So while there is no diversification opportunity in Sectoral funds, it is still possible, to a small extent, in Thematic funds. Yet both Sectoral and Thematic funds are much less diversified than market-cap linked categories like large-cap and midcap funds.

But lack of diversification in Thematic funds brings its share of problems (as well as opportunities). If the theme plays out as the investor expects it to, returns can be quite phenomenal. It is also possible that some sectors within the theme may do well and others won’t. But if the theme itself goes wrong, or the timing of investment in the theme is too early or too late, returns can be spectacularly bad. So it’s a high-risk, high-return kind of bet.

Getting the theme right is not as easy as it may look. Or else, everyone would have been a thematic investor by now.

Should you invest in Thematic funds?

Let’s step back a bit. Why do people like us invest in mutual funds? Because it’s not easy to pick good stocks consistently. Also, mutual funds provide an easy vehicle of diversification among stocks and help spread the risk.

But when you invest in a Thematic (or even a Sectoral) fund, you are going against the fundamental premise of diversifying via a mutual fund, isn’t it?

Most people who want to bet on themes are looking to generate returns higher than market returns by concentrating their bets on one sector/theme. It’s not wrong. It just comes with additional risks that may not be palatable to most investors.

Also, many of the themes can take years to play out. And not many investors have the patience to wait for returns.

In my view, Thematic funds are best avoided by most investors. It’s the same stance I took on Sectoral funds when it comes to investment products to avoid. Even so, some investors can find these useful –

* Investors who have a high-risk appetite and a lot of patience. The theme can go wrong or it may take a lot of time to play out. So you need patience as well as risk appetite.
* Sophisticated investors who are well-informed and have a good understanding of coming tailwinds that can accelerate the stocks that are part of the theme.

* For some investors, thematic funds can be a substitute for a single-stock bet that they may be planning to take. Picking a single stock from a potentially ripe-for-rise sector is not easy. In such a case, taking a basket approach via Sectoral/Thematic funds can be considered.

A word of advice: Asset Management Companies (AMCs) will regularly launch new Thematic funds cheering new-found investment opportunities in new themes. But more often than not, these launches are more about gathering assets rather than anything else. So don’t fall for this trap, please.

How much to invest in Thematic funds?

Assuming you understand the risks and what we discussed earlier, if you still want to invest in Thematic funds, then how much to invest in them?

There are two ways to go about it.

* Limit your Thematic/Sectoral exposure to 10-15% of your portfolio. Anything less will not move the needle much if the bet does well. Anything more will increase the portfolio concentration risk a lot higher than what may be prudent.

* If you follow the Core & Satellite approach to handle your mutual funds, the Thematic funds can be part of your Satellite portion. The core should always be made up of diversified schemes from categories like index funds, large-cap funds, large & midcap funds, Flexicap funds, midcap funds, and so on. The satellite portion can consist of funds from categories that offer high-risk, high-reward like Sectoral funds, Thematic funds, even small-cap funds!

Also, before bringing in a thematic fund into your portfolio, do check how that theme (and its stocks) are already represented in your existing mutual funds. It may not be a good idea to invest in a theme whose stocks already have a large enough allocation in your diversified funds.

So all said and done, if you are not sure about a sector or a theme, then best avoid Thematic funds. It’s not for everyone. The purpose of mutual funds is to help you build a diversified portfolio. Always keep that in mind.

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