Sectoral, thematic funds: Investors should avoid extrapolating past returns

Such behaviour leads to chasing funds that are past peak performance

Sectoral, thematic funds have received strong inflows worth Rs 11,848.4 crore over the past three months. On October 31, these funds had assets under management (AUM) of Rs 2.18 trillion.
 

NFOs, strong returns attracting flows
 

Recently several sectoral/thematic new fund offers (NFOs) belonging to diverse sectors such as innovation, transportation, logistics, consumption, and technology were launched. “Investors get drawn to seemingly exciting opportunities which these funds often represent,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor.
 

Performance chasing is another driver. “Investors tend to go by high returns. Several sectoral/thematic funds have delivered very strong one-year returns — higher than diversified equity funds,” says Bhavana Acharya, co-founder, PrimeInvestor.in.
 

Vehicle for high-conviction bets
 

A diversified equity fund tends to have limited allocation to a particular sector or theme. A sectoral/thematic fund allows investors to take targeted exposure. “Investors who hold a view on a specific sector or theme can implement it through these funds,” says Gautam Kalia, senior vice president and head–super investors, Sharekhan by BNP Paribas.
 

Belapurkar says that through these funds sophisticated investors can take exposure to a specific sector or theme that is currently undervalued but looks poised for a turnaround.
 

Most importantly, these funds hold the potential to yield very high returns. A sectoral/thematic fund tends to top the returns chart in most calendar years.

 

Lumpy, volatile returns
 

Investing in these funds comes with considerable risks. “Their returns tend to be lumpy, stemming from their focus on narrow sectors and themes that experience fluctuations in performance,” says Belapurkar.
 

They can also induce investors to make poor choices. “Sector performance tends to rotate. The same sector does 

not always remain at the top. But investors tend to look at past returns and extrapolate it into the future,” says Belapurkar.
 

Technology funds performed exceedingly well in 2020-2021 — in the aftermath of the Covid crash. However, a large part of investor money flowed into these funds after they had already run up (and were poised for a downturn). “Most investors who put money after a substantial portion of the rally was already over underperformed the broader market,” says Belapurkar. The biggest challenge in these funds is getting the timing of entry and exit right.
 

Investors need to be cognisant of the high risk in them. “If a theme does not take off as anticipated,  that part of the portfolio will remain subdued and will detract from the overall portfolio return,” says Acharya. Downturns in a sector/theme can last for a considerable period.  
 

Should you go for them?
 

Only investors with a high-risk appetite should go for these funds. “People looking to add concentration in their portfolios in the hope of higher returns, and willing to take the volatility that comes with this move, may opt for them,” says Kalia. They are better suited for financially savvy investors. “These funds are suitable only for investors with strong conviction and detailed knowledge about a particular sector or theme, who have conducted thorough analysis. They should enter beaten-down sectors when they are poised for a turnaround and exit once euphoria kicks in,” says Belapurkar.
 

These funds should be included in long-term portfolios, where there is adequate time for low returns or mistimed calls to be reversed.
 

These portfolios must also be large-sized. “Small portfolios may already be adequately diversified with equity, hybrid, and debt funds. Including sectoral/thematic funds will only increase the number of funds you need to track and complicate your portfolio. More importantly, mistimed sector calls have a higher impact on the returns of smaller portfolios,” says Acharya.
 

When investing in these funds, check for overlaps with sectors and themes to which you already have high exposure via diversified funds.
 

According to Kalia, these funds should be held in an investor’s satellite portfolio, and this portion should only be developed after an investor has built a well-diversified core portfolio. The investment horizon should be whatever is required for the call to play out. “Investors with lower risk tolerance, who prioritise capital preservation, should avoid these funds,” says Ameen Ahmed, founder, Trading Game Strong.