When it comes to investing, experts often advise long-term investors to avoid chasing trends as it can potentially derail their financial plan. However, the investor behavior we have been witnessing in the recent past is quite the opposite. In the first three months of financial year 2024-25, approx 33% or one third of the overall gross inflows in equity mutual funds have gone into thematic and sectoral funds. Needless to say, a large chunk of this money has gone into funds which invest in the “hot” sectors and themes. In other words, investors seem to be chasing the trends. Now the important question is: Is this a healthy phenomenon in a country where mutual funds penetration is still extremely low and a large proportion of current mutual fund investors have just started investing in the past few years?
Thematic and sectoral funds are typically meant for seasoned investors who have their core portfolio in place and who seek a tactical play based on their views on a particular sector or theme. Unfortunately, many investors who are relatively new to investing also seem to be investing in such funds in a big way. This is reflected in the number of folios in the sectoral and thematic funds category which stands at 2.25 crore as of June 2024, the highest among all equity fund sub-categories (refer table 1 below).
ETMarkets.comWhy are investors flocking to thematic and sectoral funds?
There are multiple reasons driving such inflows into this category. Firstly, there are many investors who rely primarily on recent performance of funds to make their investment decisions. Now, at any given point of time, some or the other sector will have significantly better short term performance than the diversified portfolios. Thus, typical performance chasing investors end up investing in funds that invest in such sectors or themes. Secondly, many investors seem to believe that they have the ability to make mutual fund investment decisions on their own without any professional assistance. This could have potentially led to such suboptimal investment decisions. As they say, overconfidence precedes carelessness. Lastly, many asset management companies also look to benefit from such euphoria around certain sectors or themes, especially in a bull market, by launching and aggressively marketing new funds that invest in those specific sectors or themes.Should one invest in sectoral and thematic funds?
As mentioned earlier, funds that track specific sectors or narrow themes are typically meant for seasoned investors who seek a tactical play based on their short term sectoral views. Investors who are relatively new to investing are better off focusing on well diversified funds to have their core portfolio in place and gain investing experience across at least one full market cycle before considering investment in sectoral and thematic funds. For most investors, there may not be a real need to have sectoral or thematic funds in their portfolios to achieve their long-term financial goals. Moreover, if a particular sector or theme is poised to do well, then nothing stops the diversified funds from being flexible to increase allocation to it and yet provide the benefit of necessary diversification required in the fund’s portfolio.
What are the risks of investing in sectoral and thematic funds?
Over short term horizons such as 1 year or 3 years, one will invariably find some individual sector(s) outperforming the broad based portfolios. But the outperforming sector typically keeps rotating which makes it extremely risky to chase sectors based on their past performance. For eg. The IT sector had shown significant outperformance from 2017 to 2021, however it turned out to be amongst the worst performing sectors in the past three years. Likewise, PSU stocks have shown solid outperformance vs broader portfolios like Nifty 500 in recent years but were underperformers in the previous years (refer table 2 below).
ETMarkets.comSuch ups and downs are common in sectoral funds or funds that track narrow themes resulting in significantly higher risk in such funds as compared to diversified equity funds. This is reflected in the volatility and maximum drawdown data presented below (refer table 3). For eg. Over the past 10 years, the max drawdown in Nifty 500 index (diversified portfolio) has been approx 38% as compared to max drawdown of ~50% in PSE index (comprising portfolio of PSU stocks).
ETMarkets.comIn Conclusion
Sectoral and thematic equity funds tend to be significantly more risky than the diversified equity funds. Investors should focus on building their core mutual funds portfolio using well diversified equity funds across categories such as flexi cap, large cap, value, large and midcap, etc. Seasoned investors who have their core portfolio in place and have experience of investing across market cycles could consider tactical allocation to sectoral and thematic funds depending on their views on the underlying sector or theme. Investors who are relatively new to investing or who do not have strong views on future performance of a specific sector or theme will do well to stick to their core portfolios.
(The author Nilesh D Naik is Head of Investment Products, Share.Market. Views are own)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)