While sector funds are based on investment in a particular industry or sector group, the thematic funds are much broader. A thematic fund are a part of equity trading which can be a group of sectors or a group of companies woven by a common theme. While sectors are better understood, let us look at themes with some key examples.
Banks, NBFCs, auto stocks and realty stocks tend to benefit from falling interest rates. Hence these are rate sensitive stocks. Hence we can create a rate sensitive theme and select stocks from these sectors.
One can look at consumption as a theme where you can cover sectors like FMCG, consumer durables, housing etc, which are likely to benefit from greater consumption spending and higher income levels.
It is also possible to make it more focused on rural consumption via higher farm incomes based on higher MSP on Kharif and Rabi crops. The sectors can include hybrid seeds, agro chemicals, drip irrigation systems, rural banking, two wheelers etc.
There are thematic commodity funds which focus on precious metals, hydrocarbons and on industrial metals. Such thematic funds can invest in companies into steel, copper, aluminium, crude oil and even gold mining.
In short, while a sector fund typically focuses on just one particular industry group thematic funds are slightly broader representations than sector funds and they focus on themes that can combine companies across sectors based on a common theme. Two things you need to remember; firstly, thematic funds are relatively more diversified than sector funds and secondly, your sector fund and thematic fund must not exceed 15% combined of your overall equity fund portfolio. That is a discipline you need to maintain.
How to select between sector funds and thematic funds?
There is an irony here. Most sector funds and thematic funds get launched at the peak of the market rally or when the valuations of such themes or sector is already steep. So time your purchase of sector funds properly. For example, 2002 was the best time to buy technology funds.
Any investment in sector funds or thematic funds should be with a strict stop loss only. You can put a stop loss of 15-20% and at that level just exit the particular fund without thinking twice. That is a discipline you need to hold, otherwise there is just too much risk in these sector fund and thematic funds.
The proof a story lies in the earnings and you must 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 could not keep pace with the valuations and ended disastrously.
You need supply of quality paper to buy themes. Can you thematic fund find enough good stocks in the market at reasonable valuations. 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. You would have been better off in a diversified fund as it is stretching ones imagination too far.
When it comes to themes, focus if the theme is sustainable. For example we have been hearing about defence as a big opportunity for more than 10years 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 performance and stock appreciation are another thing altogether.
Apply the test of affordability to your investments in sector funds and thematic funds. Don’t buy these funds at valuations that are ridiculous. You are paying for the froth which is not worth it. When you are planning your finances, you must assume that the worst could happen in such funds. Never predicate the achievement of your future goals based on the performance of your sector funds and thematic funds. They are meant for temporary alpha and not for sustained and consistent performance.
One final word! There is nothing wrong in buying sector funds and thematic funds if you know the limits and also the limitations. You just need to keep them within limits. Don’t go overboard with lofty expectations and keep a worst case mental stop loss. Look at these sector funds and thematic funds as an opportunistic bet on excess returns in the market. They are not a substitute for your diversified mutual fund exposure!