A checklist before investing in sectoral and thematic funds - Motilal Oswal
A checklist before investing in sectoral and thematic funds - Motilal Oswal

A checklist before investing in sectoral and thematic funds..

A sector fund or a thematic fund is a more specific and focused fund compared to a diversified equity mutual fund. For example, a sector fund will typically focus on just one particular industry group. So, you have pharma funds, IT Funds, Banking Funds and FMCG funds available as examples of focused sectoral funds. Thematic funds are slightly broader than sector funds and they focus on themes rather than on an industry. For example rural consumption may be the theme of a mutual fund and it will invest in all sectors that benefit from the theme. When rural incomes increase, then rural demand also increases and that creates demand for a plethora of products like agri-inputs, two-wheelers, discretionary consumer products, white goods etc. So a thematic fund with focus on rural consumption can invest in all these stocks that look to ride the rural spending theme.

There is a basic rule to remember here. You invest in mutual funds for the sake of diversification of risk. Direct stocks are risky and mutual funds spread your money over a larger universe. Therefore a sectoral fund or a thematic fund actually goes against the basic strategy of diversifying your risk since they concentrate your risk in a particular theme or sector. Hence your investment in sector funds or theme funds should meet two necessary conditions. Firstly, it must be a small proportion of your overall mutual fund portfolio and cannot be a core investment strategy. At best your investments in sector funds and thematic funds can be in search of that elusive alpha. Secondly, your exposure to the sector funds must be for the period the theme or sectoral interest lasts and not beyond that. Let us look at a checklist of 8 items that you must focus on before buying a sector fund or a thematic fund in your portfolio..

 

Checklist for sector funds and thematic funds..

 

When you choose a sector fund you must take a clear view of the valuations (in terms of the historical P/E ratio) of the sector to make a good investment bet. For example, most funds have the tendency to launch sector funds at the peak of the market. For example, most of the IT funds came out with NFOs in the peak of 2000 and therefore created huge losses subsequently. Similarly, most of the infrastructure-related sector funds came out with their NFOs at the peak of the boom in 2007 and 2008. Be cautious!

The previous point logically leads to the second point; always enter into a sector fund or a thematic fund with a strict stop loss. You can put a stop loss of 15-20% and at that level just exit the particular fund without thinking twice. These funds may eventually bounce back but the time value lost may be huge.

The proof of any story lies in the earnings and so you need to find out if the earnings of that sector are actually growing. If that is not happening, then it is not a risk worth taking. It will be exactly like trying to ride the tech boom in 2000 or the infrastructure boom in 2008 when the earnings just could not keep pace with the valuations.

Does the sector or theme offer enough quality stocks for the fund to invest in? This is an important question. For example, in the early 2000s many IT funds were launched and most of these funds started investing in banking stocks on the pretext that these banks were investing heavily in technology. Frankly, you would have been better off in a diversified fund.

When it comes to themes, you need to be very careful that the theme is sustainable. For example we have been hearing about defence as a big opportunity for the last 5 years but we are yet to see any worthwhile outperformance from defence stocks. Similarly, rural consumption theme is yet to play out in a big way. Identifying a theme is one thing and getting investment opportunities is another.

Read what the analysts are talking about. Normally, analysts tend to talk about themes well in advance. Check out the logic of the arguments put out. You do not want to just end up buying on hope. You need to see actual companies leveraging on the themes and actually making money out of it. The analyst reports can give you a lot of insights.

Ensure that the sector or theme you are investing in offers the potential to build intangible assets. The reason the FMCG or the private banking theme has sustained for so long is that they have been able to build an intangible brand. That is exactly where IT and pharma have faltered in their global ambitions. Similarly, don’t get carried away by commodity themes. They have always been cyclical and will continue to be cyclical.

Finally, apply the test of affordability to your investments in sector funds and thematic funds. We have already mentioned about a stop loss protection in case of these funds. But when you are planning your finances, you must assume that the worst could happen in such funds. Please do not predicate the achievement of your future goals based on the outperformance of your sector funds and thematic funds. That could be bad for your overall long term financial goals.

There is nothing wrong in buying sector funds and thematic funds. You just need to keep them within limits. Above all, don’t go overboard with lofty expectations. Look at these sector funds and thematic funds as an opportunistic bet on excess returns in the market. That is all!
 

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