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What are the risks of investing in thematic funds

05 Jan 2023

What do we understand by thematic funds as distinct from sector funds? Ok, the difference is quite subtle in the sense that sector funds are restricted to one industrial group but thematic funds can be a combination of industries. For example, a banking fund will only invest in banking stocks. On the other hand there could be a theme called rural consumption. Here the fund manager can take a much broader view and invest in sectors that benefit from the theme of higher rural consumption. So the thematic fund, in this case, can invest in fertilizer stocks, agro chemical stocks, hybrid seeds stocks, two wheeler stocks, tractor stocks etc. In this case the theme is rural consumption and all sectors or companies that can leverage this theme become likely candidates for investment by a thematic fund.

So, are thematic funds good? What has been the performance of thematic mutual funds India? Above all, what are the advantages and disadvantages of thematic investing? To cut a long story short, investing in thematic fund is not just about getting your theme right but also having the patience for the theme to fructify. That may predicate on factors that are not entirely in your control. Let us first understand the key risks of investing in thematic funds in the Indian context..

Thematic funds can concentrate your portfolio risk
Thematic funds are less concentrated compared to sector funds but are still more concentrated compared to diversified equity funds. The concentration risk can arise in thematic funds for a different reason altogether. Take the case of the same rural consumption story back in mid-2016. The setting was absolutely perfect with a bumper agricultural crop and the government committing higher funds to the farm sector. Had you invested in a rural consumption theme fund at that point of time, you would have been in for a shock in November when the government announced the demonetization drive. It created a sharp liquidity crunch in rural areas and these rural consumption stocks were the worst hit. Your theme would have really disappointed you in the first half of 2017.

Not all great themes translate into stock market returns
Take the case of digital media. We have been hearing of how the prospects of DTH companies and digital media companies could explode if India shifts to digital media in a big way. While that transition has started off in right earnest, we are yet to see any meaningful outperformance by DTH and digital media companies. The reason is that it has not made any big difference to the profitability of these digital media companies. So if you have opted for a thematic fund based on digital media, you are likely to be disappointed for a very long time. The question is whether you really have the requisite patience.
You may overexpose your portfolio to negative triggers
While sector funds have sectoral fund have sectoral triggers, thematic funds tend to have thematic triggers. The impact of demonetization on the rural theme story is a case in point. Take the case of infrastructure as a theme. Higher government investment in infrastructure is a big boost for this theme. But the huge exposure of banks to infrastructure NPAs is an overhang. Any decision by the banks to get tough on these NPAs could have negative repercussions on this theme which you need to be prepared for. You may believe that you are better off than in case of a sectoral fund but actually your vulnerability to negative triggers could be quite high.

Critical mass is the missing link in most thematic funds cases
It is said that in the thematic fund story there is many a slip between the cup and the lip. The potential of software industry was known since the 1980s. However, it took another 20 years for the industry to attain critical mass and become meaningful investment themes. That is how long thematic funds can take to fructify so just as being late is dangerous, even being too early can be dangerous in case of thematic funds. That is because the attainment of critical mass can at times take much longer than expected. Then there is the bigger challenge of profitable growth. Indian telecom companies learnt how to create critical mass but forgot how to do it profitably. That killed the telecom and connectivity theme entirely.

Global factors can be a major threat for the fructification of thematic funds
When you understand triggers pertaining to thematic funds, the triggers can come from a variety of sources. Take the case of the unwinding of the technology theme in 1999 and the unwinding of the infrastructure theme in 2008. In both the cases, the actual trigger for the end of the theme play came from abroad. That is the big risk as you do not have any control or any warning signals. Any thematic fund entails tracking a plethora of domestic and international triggers that could bring the theme into danger. That is the big challenge!

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