Sector & Thematic Funds: Rising Popularity

In recent years, sector and thematic funds have gained significant traction among investors. In fact, over the past 12 months, more than a third of the net inflows into equity mutual funds have been directed toward these categories. Once ranking as the fifth-largest equity fund category, sector and thematic funds now hold the top position, propelled by recent strong performance.

This surge in popularity has spurred several new Sector & Thematic NFOs (New Fund Offerings) from different Asset Management Companies (AMCs), leaving investors to ponder a key question:

Should these funds be part of your portfolio?

Let's break down the key challenges you need to consider before investing.

1. Cyclical Performance: Understanding the Fluctuations

Sector and thematic funds are highly cyclical in nature. While it's tempting to invest in the best-performing fund of the past year, relying solely on past performance can be misleading. Historical data shows that outperformance in these funds is often followed by periods of underperformance.

1-Year Rolling Returns

For instance, analyzing the rolling 1-year and 3-year returns of sector and thematic funds compared to broader indices like the Nifty 500 TRI reveals that sectors do not consistently outperform the market. For every period of exceptional gains, there is an inevitable downturn. This cyclicality arises because most sectors are sensitive to changes in the business and economic environment.

3-Year Rolling Returns

Key Takeaway: If you're chasing top performers, be aware that the cycle may reverse. Success in sector and thematic investing requires the ability to assess cycles and act counter-cyclically—buying when the sector is out of favor and exiting when it’s overvalued.

2. Timing the Market: The Complexity

Unlike diversified funds, sector and thematic funds demand precise timing. To outperform, you need to master three key aspects:

Valuation Cycles: Enter when valuations are low and exit when they're high.

Earnings Cycles: Invest when the sector is at the start of its earnings recovery and exit when earnings growth peaks.

Fund Selection: Pick a fund that remains true to its theme and doesn't dilute its strategy over time.

Getting all three right consistently is challenging, especially over the long term.

Key Takeaway: Even experienced fund managers struggle with successfully timing sectors over extended periods.

3. The High Cost of Mistiming

Sector and thematic funds can underperform sharply if mistimed. The extent of underperformance can be staggering, erasing years of gains. Concentration risk plays a significant role in this, as these funds often have 5–10 stocks dominating the portfolio, leaving them vulnerable to market fluctuations.

For example, some funds have seen underperformance by over 100% on a 5-year rolling basis compared to the broader market. The impact of mistiming can be severe due to:

Sectoral concentration risk: Funds focus on a single sector/theme.

Stock concentration risk: A small number of stocks make up the majority of the portfolio.

Key Takeaway: The margin for error is slim—mistiming can lead to significant losses.

4. Buy-and-Hold Strategy: Not Always Effective

A "buy and hold" strategy, which works well with diversified funds, may not be as effective for sector and thematic funds. Data shows that even over a 7 to 10-year period, many sectors underperform the broader market.

While diversified funds benefit from long-term exposure across multiple sectors, thematic funds can lag for prolonged periods. Simply extending your investment horizon may not compensate for bad timing in these funds.

Key Takeaway: Holding onto a sector or thematic fund long term doesn't guarantee success. Sometimes, long-term underperformance can persist.

5. The Issue of Under-Allocation

One major issue with thematic and sector funds is that most investors, even if they get the theme, timing, and fund selection right, tend to allocate a small portion of their portfolio to these funds (often less than 5%). This minimal exposure may not significantly impact the overall portfolio performance.

Key Takeaway: To meaningfully boost returns, you’ll need a larger allocation to these funds. But this also increases risk.

What Should Investors Do?

Given these challenges, most investors are better suited for diversified equity funds where patience and a long-term horizon reduce the need for perfect timing.

For experienced investors with a higher risk appetite, sector and thematic funds can still play a role in the portfolio. Here’s how to approach them:

Start Small: Begin with a limited exposure (under 20%) and increase it as you gain experience and confidence.

Follow the 3U & 3O Framework:

3U for Entry:

Unloved: Look for sectors/themes that are currently unpopular.

Underperforming: Invest when they’ve lagged the broader market over 3–5 years.

Undervalued: Enter when valuations are cheap.

3O for Exit:

Over-Owned: Exit when there’s high investor interest and significant inflows.

Outperforming: Consider selling after a period of strong outperformance.

Over-Valued: Exit when valuations become excessive.

Additional Considerations:

Risk Management: Ensure that you’re comfortable with the concentrated risks these funds carry.

Diversification: Even if you invest in sector and thematic funds, maintain a diversified portfolio to reduce overall risk.

Monitor Trends: Keep an eye on macroeconomic factors, sector-specific developments, and valuation metrics to make informed decisions.

Final Thoughts

Sector and thematic funds can offer exciting opportunities, but they come with unique risks. Their cyclical nature, timing challenges, and concentration risks make them better suited for experienced investors. If you’re willing to dedicate the time to research and closely follow the market cycles, these funds can be rewarding. Otherwise, diversified funds remain a more straightforward and reliable path to wealth accumulation.