What are thematic funds? How are thematic funds different from other ones in the market?
It is a spectrum. On one end of the spectrum, you have diversified funds, and on the other end you have sector funds. In the middle, lies thematic funds. Diversified funds are a mix of large, midcaps, small-caps, flexicaps etc. The broad idea is that the fund manager does not only focus on one particular sector but can pick stocks from different sectors. In diversified funds, there are at least five sectors and 10-15 sectors. In diversified funds, you just need to get the broad equity valuations right because the sector is automatically decided by the fund manager.
Sector funds: These are for slightly experienced investors who can analyze different sectors. In this, you have funds like only private banks, PSU banks, IT, FMCG etc. This is again very high risk because you need to get the sector call right and on top of it you need to pick the right stocks within the sector.
Thematic funds are between these two. It is not as diversified as the diversified fund or neither is it as concentrated as the sector funds. These funds have sub-sectors within the themes. It is usually a combination of two or three sectors with a broad direction. For example, manufacturing can be a theme where you can have pharma, capital goods, electronics, as well as auto.
A lot of people confuse sector funds with thematic funds quite often. What differentiates both?
From a risk point of view, thematic funds are a little lower risk compared to sector funds because in sectors you are just focusing on one single sector. Now, if that call goes wrong, your portfolio will go down. A thematic fund is less risky than sectoral funds since it is a spectrum and has 5-6 sub-segments, you are more diversified. So, the highest risk is in the sector funds, the slightly lower risk is in thematic, and even lower risk is in diversified funds.Which types of thematic funds are available in the market presently?
Themes such as financials, manufacturing, consumption, infrastructure, ESG etc. Under these, you will find a mix of sub-sectors. For example, if you go for financials – it can have NBFCs, banks, AMCs etc.
How much returns can one expect out of thematic funds?
First let’s understand this in terms of core and satellite portfolio. For a core portfolio, pick 4-5 different investment approaches which are diversified funds and let them run for 5-7 years. At least for 60% to 80% of your equity portfolio, we would want to run it in this manner to minimise the risk factor. The broad idea would be to outperform the index by at least 2-3%. So, this is our core portfolio.
The remaining 20, 30, or 40% of your folio is where you attempt a higher outperformance. This is where thematic, sector funds etc come in.
The most important thing is you need to time it right. You need to enter when the valuations are low and the fundamentals are picking up. And mostly, valuations are low only when something bad is happening to the theme. For example, IT went through a bad time in 2018-19 and post that it did well and then now it is doing badly. Again, banks, PSU banks or PSU segment went through a very bad time for almost 10 years and now they are the superstars for the last two years.
Now, how long it goes is very difficult to quantify. So, broadly the idea should be that you should come into a sector when it is at the end of its bad time. Look at reasonable valuations, you might end up getting significantly much higher returns compared to your index. But if you are entering late, you might get stuck. For thematic funds, past performance is a very bad lens. We currently like the banking and financial space at the current juncture.
Don’t you think investing in a thematic fund is like shooting an arrow in the dark? How will investors choose a particular thematic fund if they have no information about it? So, what are the main pointers to keep in mind while choosing a fund?
Yes, I would say 99% of investors should avoid thematic investing at least for the initial first 5-10 years of their investment journey. After gaining experience, start with a 20% allocation and only increase if you see your calls going right. Do not start with a 100% thematic portfolio.
Check where you are in the cycle. What does the valuation look like and, what is the earnings expectation over the next three to four years? Now, if you put these three, you will broadly get a sense.
We spoke about diversified and flexi cap funds also. Why should one go for thematic and not for flexicap?
For your 80% core portfolio, you should go for flexicap combined with midcaps and global funds. But for the remaining 20%, you can go for thematic only if you want an additional kicker in returns, you have time, interest and expertise to evaluate different segments. However, sector or thematic funds are optional and for 99% of investors, it is actually not required.
What is the risk profile of thematic funds and how much allocation can be done for thematic funds in one’s portfolio?
From a risk perspective, this is not for a first-time equity investor. Always start with a low allocation of say around 20% and within that, maybe you can take 10% for a theme. Let us say you pick two themes, 10% for a theme, and then see how it works out. Once you get good at it, bring it to say 30% or 40%. Don’t go beyond 40% at all if you don’t have the knowledge.
And how often should one just keep a check on the funds?
Unlike your diversified funds, where you can do a six-month or a one-year review, in this case, you will have to definitely keep a watch out, at least on a three-month basis.
Once the quarterly results come, you just need to check out what was your original thesis. So, it involves a lot of hard work and most importantly, the fund that you have identified is capturing the underlying theme because if you look at the financial sector and banking theme, you will find different funds have different splits. Some funds are more on banks or lenders vis-a-vis non-lenders. Some funds are more aggressive on non-lenders. So, even within those, once you have identified the theme, even within that, the funds might be playing it very differently. So, you also need to align what is your view with what is the fund manager’s view of playing that theme, so that comes the second complexity. So, which is why overall, it is a slightly harder thing to do. So, my sense is, do it only if you are very experienced and cap it to 20% of your portfolio. Do not try it with a larger portion of your portfolio.
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