As asset management companies are launching innovative thematic funds, investing in them can be a valuable addition to the portfolio to enhance the overall returns. However, individuals must note that investing in equity thematic funds carries a higher concentration risk and elevated levels of volatility.

The themes and sectors could be cyclical and investors must have sufficient information and a time horizon to take a bet on a particular theme or sector. The performance of thematic funds will depend on the time of investment as the funds may perform in different cycles. So, the potential of the sector along with the time horizon are important factors to consider and individuals will have to remain invested for a longer period of time to generate higher returns.

Also read: Pidilite expects better margin and volume-driven growth in FY24, says MD Bharat Puri

Nirav Karkera, head of research, Fisdom, says when considering a thematic fund, investors should have faith not only in the fund’s portfolio and management team but also in the theme the fund aims to capitalise on. “The thematic fund category is continuously expanding, with new funds regularly being introduced. Therefore, it is crucial for investors to research available options and determine if there are funds available that align with their confidence in a particular theme,” he says.

Given their high risk-high return nature, thematic funds can either give exceptional returns or extremely poor returns depending on the timing. In fact, investing in thematic funds requires taking a bet on four things going right: Picking a winning theme, selecting the right fund within that theme, buying at right valuations which have not already priced in the theme’s potential and the ability to identify the cycle correctly and invest closer to its start and exit as it starts to peak.

Arun Kumar, VP and head of Research, FundsIndia, says the odds of getting all the four factors right on a consistent basis is very low and the payouts can be meaningful only when we get these right. “Investors have often piled into these funds at precisely the wrong time mostly following strong past performance, only to be disappointed. Unlike in the case of diversified equity funds, where buying and holding a well-performing fund for the long term can work well, this may not always be so for such funds,” he says.

Possible themes

Investors must consider long-term investments in thematic funds that seek to capitalise on various aspects of the economic growth story. These themes could focus on specific sectors such as infrastructure, banking and technology.

Rahul Singh, CIO, Equities, Tata Asset Management, says the nature of the economy is changing from consumption driven to investment cycle driven and this may improve performances of thematic funds like banking and infrastructure. “Thematic funds may be restricted to 20% of asset allocation due to higher cyclicality involved. For highly cyclical thematic funds, entry and exit points become important,” he says.

Risk factors

While thematic funds share many of the same risks as any other equity fund, concentration risk is the major one. This can lead to significant bets on a narrow set of securities, which are often correlated due to their sensitivity to the theme. If an event or development challenges the prospects of the selected theme, this concentration risk can result in the fund’s underperformance.

Harshad Chetanwala, co-founder, MyWealthGrowth.com, says as thematic funds invest in a particular sector, the themes and sectors could be cyclical. “Considering the present scenario, it may not be necessary that all thematic or sectoral funds will deliver returns. Hence, one must have sufficient information and a time horizon to take a bet on a particular theme or sector,” he says.

Mitigating risks

To mitigate the risk, investors must first establish a core portfolio that aligns with their target asset allocation. For investors who are less clear about their strategy within or across asset classes, funds with flexible mandates such as flexi cap funds, dynamic asset allocation funds and multi-asset funds, can be a good starting point. “For those who are confident in their allocation strategy, funds with relatively tight mandates such as large-cap, mid-cap, and small-cap funds, can help build a more tightly aligned portfolio,” says Karkera.

It is always better to build the core portfolio with the help of equity diversified funds and then invest in thematic funds. Chetanwala says the core portfolio will be more diversified when compared to thematic funds and so the risk too is spread across different sectors. “Thematic funds can often be too concentrated and if the sector goes through difficult times, the entire portfolio could struggle for a while. These funds are for high-risk appetite investors,” he says.

Also read: C-PACE to simplify removal of company names from register: MCA

GETTING IT RIGHT

* Pick a winning theme, select the right fund within that theme, buy at right valuations, identify the cycle correctly & invest closer to its start and exit as it peaks

* Thematic funds should be restricted to 20% of the asset allocation due to higher cyclicality involved