Theme for a dream: Why thematic funds are gaining traction in the market

Beyond the obvious equity mutual fund winners this year, which have been mid and smallcap categories, thema­tic or sectoral funds have noticeably taken the lead. Data shows thematic equity mut­ual funds have amassed inflows worth Rs 22,871 crore as of October-end, higher than the Rs 18,855 crore gathered by the midcap category, and only second to the small-cap flows of  Rs 32,000 crore.

In contrast, the largecap category has witnes­sed net outflows of  Rs 2,894 crore in this period.

Thematic or sectoral mutual funds invest in stocks tied to a particular theme or sector. These schemes are high-risk in nature as they carry anywhere between 80 per cent and 100 per cent exposure to stocks belonging to the same industry, irrespective of their market cap. 

However, investors are evidently pouring more into these high-risk schemes as compared to the relatively diversified marketcap-based categories, despite the sharp swings in equity markets this year. 

“In diversified portfolios, one gets limited ex­p­osure to sectors. That, too, is generally restri­c­t­ed to large caps. In sectoral schemes, the investor takes as much as 100 per cent exposure to sectors in some cases and the fund manager is in­ve­s­ting not just in large caps but also mid- and small­cap stocks where value discovery takes pla­ce. Sin­ce the markets have run up, naturally inve­s­t­ors are looking to make higher returns even if they come at extra risk,” said Sachin Trivedi, head of resea­r­ch and fund manager, equity, at UTI AMC.

High appetite for risky bets

Analysts say the tilt towards sectoral funds, des­pite their risk factor, is due to several market pockets providing cyclical opportunities, and certainly the quest for higher returns in a market marred with volatility.

Notably, select sec­t­oral funds have given han­d­some returns, out­pacing those from the large- and midcap categories. That would explain why investors are flocking to them. 

Largecap equity funds on aver­age have gen­e­rated 17 per cent returns in the last three years (tr­a­iling basis). Mid and smallcap funds have given 26 per cent and 33 per cent, respectively, during this time, data from Value Research shows.

In contrast, average returns generated by public sector unit (PSU) and infrastructure sec­toral funds in the past three years are relatively higher at 36 per cent and 33 per cent, respectively. These two segments have given more or less similar returns on a one-year basis.

Pharma funds, on the other hand, are up significantly with 24 per cent average returns in the past one year, compared to an 11.5 per cent gain from large-cap funds.

The average returns by pharma funds in three years, meanwhile, are much lower at 14 per cent. This has been 17 per cent for banking funds, which in the last year have generated just 9 per cent returns.

Some of the highest-gaining schemes (direct) that have generated between 38 per cent and 42 per cent returns in the last three years include HDFC Infrastructure Fund, ICICI Prudential Infrastructure Fund, Aditya Birla Sun Life PSU Equity Fund, and ICICI Prudential Commodities Fund, among others.

Look beyond recent performance

Many investors, experts say, tend to make the common mistake of only looking at the recent performance of sectoral funds for their investing decisions, which must be avoided.  

“Investors need to be cautious when looking at funds, which gain popularity due to their past few years’ returns. Rather, pockets where the mar­­ket set-up has changed or some new oppor­tunities are arising merit consideration,” said Anand Varadarajan, business head-institutional clients, banking, alternate investments and product strategy, Tata Asset Management. 

Another crucial factor, and perhaps the most important, when it comes to investing in sectoral funds, is knowing the right time to enter and exit the market. Gauging at just the past perform­ance, for instance, investors often enter at the peak of the market, which is the wrong time for entry. Long-time underperformers, instead, should be looked at to find a suitable entry time.

“One has to be extremely informed, especially with respect to the timing. Approach a sector that is completely out of flavour, where valuations are beaten down, or maybe where they have underperformed for a while, or where the operational upturn is likely to take place. This is the best time to enter,” said Trivedi of UTI AMC. 

The fund manager recommends that the combined exposure to sectoral funds should not exceed 10 to 20 per cent of one’s overall portfolio. “The larger share should be in diversified categories like large caps and flexi caps, as sectoral funds come with their risks. In the short term, they can do really well, but in the long term the outcome could be mixed,” he said. 

AMCs make a beeline

The robust inflows in sectoral funds this year have partly been mobilised from a record number of new fund offers (NFOs) that have far outstripped those in 2022. About 22 sectoral, or thematic, NFOs have been floated between January and October this year, as against just 7 in the same period last year.

Of the total sectoral fund inflows during January-October 2023, about 54 per cent, or Rs 12,372 crore, have been from the 22 new schemes alone. Asset management companies (AMCs), experts say, are coming up with these offerings not only to meet the demand for such funds but also due to a market that is becoming saturated.  

“We are seeing a mature market in India where large AMCs are already done with standard diversified offerings like largecap, and mid and smallcap funds. This is why now they are looking to complete the bouquet with newer offerings like sectoral or thematic funds, which find favour with the informed investor group,” Trivedi of UTI AMC said.

 As far as the outlook is concerned, fund managers believe if a broader market rally creates opportunities in the largecap space, sectoral funds could see a slowdown. However, this primarily depends on where the high-risk investors think it fit to invest. 

Sectoral flows, said Vardarajan of Tata Asset Manage­ment, dry up depending on their cyclic­ality. Investors, he suggests, must evaluate the business cycle from an 18- or 24-month persp­ective, and only then jump into thematic funds.