Decoding Sectoral vs Thematic Mutual Funds

A high-risk high-reward investment product may not be on the watch list of several investors, particularly the new entrants. But an aggressive approach, considering India's prospering economy and stable outlook, can translate into a huge wealth creation plan. Vardan Pandhare explores the investment opportunities of sectoral and thematic mutual funds in your portfolio.[EasyDNNnews:PaidContentStart]

One of the frequent idioms, used in sports, especially in cricket, is the word 'daring' - meaning bold or fearless. Considering the same in the realm of investment, being brave sometimes helps in attaining your financial goals quickly and securely as well. In the big gamut of mutual funds, two categories - sectoral and thematic mutual funds - are two such avenues, where a calculated risk can help you steer it clear towards wealth creation.

Sectoral versus Thematic Mutual Funds

Sectoral and thematic funds represent open-ended equity mutual fund schemes that focus on investing either in a singular sector or multiple sectors tied together by a central theme. Thematic funds cater to investors looking to allocate funds to stocks aligned with particular concepts, while sectoral funds offer targeted investment prospects within distinct sectors like IT, pharmaceuticals, automotive and FMCG, among others, all of which exhibit promising growth potential.

Both sectoral and thematic funds have the flexibility to invest across the spectrum of company sizes, encompassing Large-Cap, Mid-Cap and Small-Cap entities. Moreover, they are both required to allocate a minimum of 80 per cent of their total assets to the specific sector or theme that the fund centres around, adhering to the guidelines set forth by the market regulatory authority, SEBI. The performance trajectories of companies operating in diverse sectors such as banking, pharmaceuticals, automotive, metals, FMCG, IT, and more, are characterised by their distinct and evolving seasonal, cyclical and structural business cycles.

Over any given period, each sector exhibits distinct performance patterns. For example, it's widely recognized that automobile sales often dip towards the close of the calendar year, while numerous companies tend to unveil new products between January and March. Such trends are mirrored in the financial performance of these companies. In this context, both sectoral and thematic mutual funds serve as valuable tools for investors seeking to leverage these specific opportunities to enhance the growth of their investments. So, what sets sectoral and thematic funds apart? Well, one major differentiator is the investment philosophy.

Sectoral Funds Revolve Around a Singular Sector

The core objective of sectoral funds is to predominantly invest in enterprises operating within a specific sector. These funds channel their equity exposure into a solitary sector such as banking, pharmaceuticals, FMCG, IT, automotive, metals, and the like. To give you an example, the coronavirus-triggered pandemic presented diverse avenues for advancement in sectors like pharmaceuticals and technology. A fund exclusively dedicated to the pharmaceutical domain would pinpoint investment prospects within that sector, aiming to capitalise on potential high-growth returns. Similarly, an infrastructure sector fund would allocate resources to businesses engaged in and benefiting from the expansion of Indian infrastructure and correlated endeavours.

Thematic Funds Span Multiple Sectors Linked by a Common Theme

Thematic mutual funds adopt a broader perspective concerning the pool of viable investments, and as such, strive to predominantly invest in firms influenced by a designated theme. These firms typically span multiple sectors. As a result, the scope and investment purpose of a thematic fund surpasses that of a sectoral fund. For instance, a theme like growth propelled by rural income could encompass several sectors. An uptick in rural incomes augments rural demand, stimulating the need for products such as agricultural inputs, two-wheelers, discretionary consumer goods, and household appliances. A thematic fund concentrating on rural consumption would then invest in all these stocks poised to leverage the rural spending trend.

Similarly, a fund centred on an ESG (environmental, social, corporate governance) theme would invest in companies that have excelled in environmental, social, and corporate governance aspects. These companies might hail from diverse sectors like technology, financial services, FMCG, automotive, metals, and more. Thematic funds might also encompass special opportunity funds targeting businesses involved in corporate activities like IPOs, buybacks, mergers, demergers, etc. In nature, thematic funds have the flexibility to allocate resources across various sectors and market capitalisations, as long as their investments align with the overarching theme.

Differences between Sectoral and Thematic Funds

SIP Growth : Indian Mutual Fund industry currently has around 6.81 crore SIP accounts. Systematic Investment Plan or SIP has been gaining popularity among Indian MF investors, as it enables Rupee Cost Averaging and helps in investing in a disciplined manner without worrying about market volatility and timing the market. 

Tax Regulations Applied to Sectoral and Thematic Funds

Following the Income Tax Act provisions, sectoral and thematic funds are treated similarly to other equity-oriented funds when it comes to taxation. The tax implications are as follows:
1. For investments held for less than 12 months, the profits are subjected to short-term capital gains tax at a rate of 15 per cent (plus relevant surcharge and cess).
2. For investments held for a period exceeding 12 months, the profits are liable to long-term capital gains tax at a rate of 10 per cent (plus relevant surcharge and cess).
3. Under the framework of the Income Tax regulations, there exists an annual exemption of up to ₹1 lakh concerning long-term capital gains derived from equity shares and equity-oriented mutual funds.

Performance Analysis of Sector versus Thematic Mutual Funds



The graph above shows that the sectoral funds have had a slight edge in the highest returns over the past 10 years, followed by the thematic funds. While sectoral funds score higher in the first year giving average returns of about 20 per cent, the three-year returns for the thematic funds are higher, suggesting a neck-to-neck competition. However, the five-year returns for the sectoral funds are higher than the returns for the thematic funds. This suggests that sectoral funds may be a good choice for investors who are looking for high returns over the long term. 

However, it is important to note that the returns of these funds can be volatile, so investors should be prepared for the possibility of losses. The thematic funds may be a good choice for investors who are looking for a more stable investment with the potential for good returns over the long term. Ultimately, the best way to decide which type of fund is right for you is to talk to a financial advisor and conduct your own research. They can help you assess your investment goals, risk tolerance, and time horizon and recommend the right funds for you. 

If we consider only the five-year returns, the following are the top five fund categories:
1. Sectoral-Technology: 19.14 per cent
2. Thematic-Energy: 18.69 per cent
3. Multi-Cap: 19.22 per cent
4. Small-Cap: 18.69 per cent
5. Thematic-Consumption: 17.33 per cent

As you can see, sectoral and thematic mutual funds have outperformed their peers such as multi-cap, small-cap, mid-cap, value funds, etc. However, it is important to note that past performance is not a guarantee of future results. Investors should always do their own research before investing in any mutual fund.

Portfolio Composition

Can sectoral and thematic funds be a part of your core and satellite portfolio? In goal-oriented financial planning lies the concept of asset allocation. Once the selection of assets is completed, the subsequent phase involves decision-making regarding investments. This introduces us to the strategy known as the core and satellite portfolio. So, what exactly constitutes a core and satellite portfolio? As the name implies, the ‘core’ element forms the foundation of an investor's portfolio. When dealing with core investments, it's prudent to avoid taking on more risk than what is already inherent in the overall risk profile of that particular asset class. Maintaining a robust level of diversification is also crucial for the core. The core segment of the portfolio imparts stability and is tailored to fulfil significant long-term objectives, such as retirement planning or funding a child's higher education. One of the suggested combinations in the core-satellite approach is the 80:20 mix, in which 80 per cent of the portfolio is dedicated to the core, while the remaining 20 per cent constitutes the satellite segment.

Representation of a Potential Core and Satellite Portfolio

This strategy aligns with your overall asset allocation framework. For example, when dealing with equity investments within the core and satellite portfolio, the cumulative equity exposure should match your intended equity allocation for the entire portfolio, and this principle extends to other asset classes as well. What drives the creation of a core-satellite portfolio? This strategy provides access to the advantages of both realms without compromising your objectives. The core component of the portfolio is generally kept relatively stable, and while funds can flow from the satellite portion to the core, the reverse is seldom the case. 

Factors to Consider Before Investing

 ∎ Before investment, ascertain that the fund boasts a robust track record spanning at least 3-5 years.
 ∎ Opt for a fund associated with a reputable fund house that has a commendable track record. n Confirm that the fund offers diversification across a range of stocks.
 ∎ Select a scheme that ranks among the top performers within its designated category.
 ∎ Place importance on an experienced and capable fund manager.
 ∎ Evaluate the fund house's well-defined investment systems and processes.
 ∎ Ensure the scheme aligns with its stated objectives, indicated asset allocation, and investment style.
 ∎ Rather than fixating solely on a scheme's past or current performance, take into account the future potential of the targeted sector or theme.
 ∎ When engaging in investments within sectoral and thematic funds, a crucial aspect is to understand the right moments for entry and exit within the designated sector or theme.

This approach ensures the security of your goals even if some riskier investments fail to perform as anticipated. Thematic funds present an appealing choice for ‘investing in the future for the future’, and investors should allocate a portion of their satellite portfolio to investments in thematic funds. When adopting a core and satellite methodology, the satellite segment can be directed towards thematic funds, while the core component could consist of broad-based indices like Nifty 50 and Sensex in case of equity exposure

Thematic or Sectoral: Which Route to Take?

Thematic and sectoral funds pursue distinct investment strategies. While thematic funds aim to capitalise on emerging trends by investing in leading companies across the entire ecosystem, sectoral funds focus exclusively on a specific category of companies. Take the case of electric vehicles as an example. A thematic fund will invest across the entire production chain, encompassing mining firms, auto component manufacturers, and battery producers. On the contrary, a sectoral fund will concentrate solely on original equipment manufacturers or auto ancillary companies. Thematic funds might be preferable due to their broader ecosystem coverage, leading to lower concentration risk.

Who Should Invest in Sectoral and Thematic Funds?

Sectoral and thematic funds present the potential for higher returns, yet they come with notable volatility and carry elevated risk levels. As such, these investment options are best suited for individuals who possess a high tolerance for risk. Investing in sectoral and thematic funds demands a keen sense of market timing. Thus, a comprehensive grasp of sector-specific intricacies is essential. Given their pronounced volatility, these funds are particularly well-suited for investors with an exceptionally strong risk appetite and long-term investment horizons. Although sectoral and thematic funds may deliver on short-term return expectations, they have the potential to encounter setbacks and require considerable time for recovery in the long haul, necessitating alertness on the part of investors.

Conclusion

Sectoral funds allocate their investments to specific sectors such as pharmaceuticals, banking, real estate, and the like. In contrast, thematic funds channel their investments into overarching themes centred on ideas or objectives that span across multiple sectors. These funds both fall into the category of high-risk, high-return equity funds, with thematic funds offering a marginally greater level of diversification compared to sectoral funds. 

A final piece of advice: There's no harm in considering sectoral funds and thematic funds provided you are aware of their boundaries and limitations. It's essential to exercise restraint. Avoid becoming overly optimistic and establish a mental ‘stop loss’ to manage potential downsides. Regard these sectoral and thematic funds as calculated risks on achieving surplus returns within the market. Remember, they don't substitute for the diversified exposure offered by your other mutual fund investments.

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