Thematic equity funds are becoming popular. There is one to play the consumption theme; another to ride the business cycle. Some to capitalize on the IPO boom, while others operate in the PSUs and infrastructure space. The new-kid-on-the-block – ESG fund in turn scouts for investment opportunities across sectors that fare well on environmental, social, and (corporate) governance factors.

Should thematic funds be part of your equity portfolio at all?

Difference between thematic and sector funds

Thematic funds are essentially tied to a broader theme as against being focused on market capitalization (large-cap, mid-cap and small-cap), sector (pharma, IT) or investment style (value, growth).

So, they are more diversified than a sector fund when it comes to investing. For instance, infrastructure funds invest in sectors of cement, steel, power, telecom, construction and oil & gas while banking, pharma, information technology and real estate funds keep a narrow focus. However, thematic funds are also less diversified than a regular equity fund.

Consider the following factors while investing in thematic funds:

1. Understand the theme

An investment theme that has a good narrative might appeal to you but might not necessarily provide higher returns for the additional risk taken. Therefore, the first question to ask is – is the theme design precise or rather one that conveys a grand vision? That’s because the themes that are defined too broadly in scope may not target the actual return opportunity.

So, check if the fund is just capturing the zeitgeist or really offering a long-term value proposition? Moreover, you need to find if the theme can evolve over time or is subject to obsolescence.

For instance, in the 90s, MNC funds were in vogue. At that point in time, foreign companies listed in India, as a lot, were considered a better investment than Indian-promoted ones. That’s because MNC were perceived to be professionally managed while enjoying a technological edge as against that of PSUs. However, the differences have blurred now. PSU funds are in fact gaining traction to capitalize on divestment and allied reforms.

So, don’t consider the theme in isolation now but its onward journey. Not just the innovation or disruption that it causes initially but also all stages of the adoption curve and company life cycles, including the ability of companies to evolve.

More thematic funds as against diversified funds have closed down or got merged with other funds as it lost relevance. Remember there is a big survivorship bias.

2. Check the Entry point in thematic funds

By the time a theme becomes popular, the macro trends are usually priced in. Once a theme starts doing well, investors flock to it – which results in such stocks becoming expensive from a valuation perspective.

It sort of neutralizes the benefits of superior growth as mean-reversion sets in. There is no point in entering a theme when it has already been delivered.

Moreover, while a theme might be attractive, it might take time to play out.

3. Satellite consideration may work for thematic funds

Thematic funds are useful for professional investors with superior understanding and in-depth knowledge of a particular sector or theme (However, ensure you stay free of the confirmation bias).

They are gung-ho about the theme but don’t have the time and wherewithal to do the stock-picking and manage a portfolio. While such investors can invest in thematic funds, they also need to know that (unlike an equity diversified fund), the fund manager does not have much latitude if a theme falls out of favour. Moreover, they need to be prepared for higher volatility.

An additional risk taken by investing in thematic funds has not necessarily been rewarded adequately in the past. A comparison of risk-adjusted returns of thematic funds vis-à-vis that of midcap equity funds – shows that midcap funds, on average, have a better risk-adjusted return metric than that of thematic funds.           

If you are still planning to invest in these funds, ensure it is a satellite consideration (10% of portfolio).

Takeaway

Investment themes that make a good narrative don’t necessarily generate higher returns to compensate for higher volatility. Keep the investment simple and boring; rather invest in diversified equity funds.