What are thematic funds?

Date : 23/06/2020
Read: 6 mins

Are you a good researcher? Do you dig into company backgrounds? Prefer to enter the fray fully prepared? Then investing in thematic funds may be your cup of tea.

A mutual fund is a shared fund that pools in money from multiple investors and invests in stocks and bonds and other financial instruments, which are chosen as per the investment objectives spelt out in the offer document.

There are many types of mutual funds, one being thematic funds. These could be either equity funds or debt funds, and they invest in stocks of companies that have a common thread or a business ‘theme’. The theme could be anything – infrastructure stocks, low-cost housing, rural India, international stocks, commodity stocks, and the like.

So, if the theme is infrastructure, the investments will be in equities of any company related to infrastructure, such as construction companies, cement companies, steel companies etc. Thematic funds are typically high-risk / high-returns funds because they are dependent on the limited number of companies or sectors they are invested in.

Not sector funds

Thematic funds are not sector funds, but they do have much in common. This is basically due to the similarities in approach and people often tend to confuse one with the other. But there are some subtle differences between the two that set them apart. Let us consider a few:

To start with, sector funds are intensely focused on a maximum of one-to-three sectors, and their investments never venture outside this narrow scope. Thus, the fortunes of a particular fund are tied to that of the sector(s) it tracks.

On the other hand, a thematic fund takes a more broad-based approach; it looks for ‘themes’, and not sectors. The investments are in sectors and companies that this theme unites. For instance, HDFC Housing Opportunities Fund, when launched, identified the theme ‘low-cost housing’, and then invested in companies benefiting from the government’s push for low-cost housing: banks, cement, steel, and paints.

Secondly, sector funds are riskier than thematic funds, as their performance hinges on the fate of that particular sector. If the sector hits a bad patch, it spells losses for the entire fund. Needless to say, fund performance is also dependent on government policies. For instance, RBI’s monetary policy will automatically impact banking and financial services companies, which will in turn impact the profitability of the funds investing in this particular sector.

Theme-based funds, on the other hand, ride the performance of the stocks from the different sectors that they are tracking. This reduces risks to an extent. However, thematic funds are not diversified enough to handle market volatility. In fact, both sector funds and thematic funds carry a high risk element.

It must also be noted that theme-based funds are not as good as diversified equity mutual funds.

Pros and cons

So what are the advantages and disadvantages of thematic funds? Let us start with the benefits:

First, as stated earlier, thematic funds invest in stocks of companies and sectors that are closely related in their business scope and nature. This semi-diversification makes investments more focused, making it easier to track their performance and exit at the right moment;
Again, as stated earlier, though these funds carry a high degree of risk, they can bring high-returns;
Thematic funds are good for you if are looking for short- and medium-term investments; the reason is obvious: you will make a killing if one of the stocks does well consistently;
Finally, mature investors who follow market trends and take informed investment decisions can reap lucrative returns from these funds.

This brings us to the disadvantages of thematic funds; let us start where we left off:

First, as opposed to profiting greatly when the going is good, conversely, you will also be hurt badly the moment one of two stocks take a plunge;
Secondly, thematic funds are basically risky. As a result, they cannot constitute your core portfolio (they should at best make up no more than 10-15% of your portfolio);
Thirdly, new or relatively inexperienced investors often find a particular fund’s portfolio misleading if they do not read the prospectus for relevant details such as investment objectives and fund manager’s background. The confusion arises as fund names frequently fail to reflect the ‘theme’;
The fourth drawback is somewhat related: analytical decisions are called for in theme-based funds, so these are not for greenhorn investors;
There is no comparable fund or benchmark for such funds; consequently, planning a strategy becomes difficult;
Finally, the performance of thematic funds focused on the international sector is hard to predict, as they are dependent on multiple factors, such as the currency values on your investment.

Tips for investing

If you know the pros and cons of thematic funds, follow certain guidelines, are prudent, and not averse to taking some risks, you can reap a windfall. For instance, the 5-year returns for L&T Infrastructure Fund Direct Plan Growth Option has been around 20%, while that for IDFC Infrastructure Fund Direct Plan Growth has been around 14.5%.

But to avoid burning your fingers when investing in thematic funds, you need to keep in mind a few points. The first thing to remember – given that thematic funds are known for the high risk and volatility involved – is that one should have a good understanding and knowledge of the particular sector that a thematic fund is targeting before investing in that fund. Also, read the prospectus carefully.

However, even if you have an understanding of the given sector, it helps a great deal in offsetting the risks if you already have a diversified portfolio of regular funds. At the same time, be prudent and don’t get carried away by reports of lucrative returns and past performances; keep your investments in this area limited to 10%.

Also, do not go by past returns of a thematic fund. It is more prudent to identify opportunities ahead for that sector or theme. This is why the timing of the investment is important: it is pointless entering the sector or theme when it has already delivered. The exit timing is equally crucial.

Last words

To repeat, volatility is part and parcel of thematic fund investments, and sudden losses and sudden gains are normal. If you have the appetite for these risks, have a long-term perspective, and follow the progress of your chosen sector diligently, you can make a bundle. And don’t forget to exit quickly.

Before you pick a type of mutual fund from the lot, it is always a better idea to understand the types, benefits, rate of return, risk factor and other aspects for the same. Here's a quick guide to understanding the types of mutual funds.