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Sectoral Thematic Funds: Benefits of Investing in Sectoral & Thematic Funds

Know the difference between investing in Thematic mutual funds and sector mutual funds as they carry high risk.
What are Sector funds & Thematic Funds?

Many investors get confused between "What are Sector funds and thematic funds." This article discusses sector funds vs thematic funds, their differences, and their risk profile compared to diversified equity funds.

What are sectoral funds?

As per SEBI’s classification of mutual funds, a sectoral fund invests a minimum of 80% of its total assets in equity and equity-related instruments of a particular sector. It is an open-ended equity scheme investing in a specified sector/industry. SEBI has sub-categorised sectoral funds under the broader category of equity schemes.

A sectoral fund, for example, a banking fund, will invest a minimum of 80% of its total assets in the shares of various banks listed on the stock exchange. The selection of bank shares and the amount to be invested in each bank share will depend on whether it is an actively managed fund or a passively managed fund.

Performance comparison of funds category average with benchmark

The benchmark for some banking funds is the Nifty Bank Index. In an actively managed fund, the fund manager can decide which companies invest in and in what proportion.

The fund manager can select the companies that are a part of the benchmark Nifty Bank Index and outside of it from the financial services industry. Then, just like buying, the fund manager can decide which company shares to sell and how much.

The fund manager of an infrastructure sector fund or an FMCG sector fund can also do the same thing. Let us compare the sector funds category average returns with the respective sector index returns.

Index1 year3 years5 yearsSince inception
Banking funds category average65.13%15.55%14.72%17.02%
Nifty Bank Index (Benchmark)53.49%9.75%14.64%19.61%
Infrastructure funds category average65.13%15.55%14.72%17.02%
Nifty Infrastructure Index (Benchmark)43.69%14.29%10.73%10.16%
FMCG funds category average65.13%15.55%14.72%17.02%
Nifty FMCG Index (Benchmark)20.98%8.58%12.25%15.14%

The above table shows that

  1. The banking funds category average returns have outperformed the benchmark in the last one, three, and five years but unperformed since inception.
  2. The infrastructure funds category average returns have outperformed the benchmark in the last one, three, five years, and since inception.
  3. The FMCG funds category average returns have outperformed the benchmark in the last one, three, five years, and since inception.

Passive sectoral fund – Banking fund – Motilal Oswal Nifty Bank Index Fund

The Motilal Oswal Nifty Bank Index Fund is passively managed (index fund). The benchmark for this fund also is the Nifty Bank Index. Since this is a passively managed fund (index fund), it will invest more than 95% of its assets in all the constituents of the Nifty Bank Index as per weightage. 

The fund manager will have no say in which stocks to invest in and how much. There is no active stock picking. Instead, the scheme will sell only those removed from the index as part of index reconstitution.

Although both the above funds are banking sectoral funds with the Nifty Bank Index as the benchmark index, there are two significant differences between them:

  1. Style of management: We have already discussed how the fund manager decides to buy/sell shares in an actively managed scheme. In a passively managed fund, the money must be invested in all the benchmark constituents, as per their weightage.
  2. Expense ratio: The expense ratio of an actively managed scheme can be much higher than a passively managed scheme. In the above scenario, the total expense ratio (TER) of Nippon India Banking Fund (active fund) is 1.39% for the direct plan as of June 2021. On the other hand, the TER of Motilal Oswal Nifty Bank Index Fund is 0.38% for the direct plan.

Sectoral indices offered by the NSE

Mutual fund houses launch sectoral mutual fund schemes with various indices offered by the NSE and BSE as the benchmark. Some of the sectoral indices provided by the NSE and some of the sectoral mutual fund schemes launched by AMCs include:

Sectoral IndexSectoral Mutual Fund Scheme
Nifty Bank IndexNippon India Banking Fund
Baroda Banking and Financial Services Fund
Motilal Oswal Nifty Bank Index Fund
Nifty Financial Services IndexUTI Banking and Financial Services Fund
ICICI Prudential Banking and Financial Services Fund
SBI Banking and Financial Services Fund
Nifty FMCG IndexICICI Prudential FMCG Fund
Tata India Consumer Fund
Mirae Asset Great Consumer Fund
Nifty Pharma IndexTata India Pharma & Healthcare Fund

Some of the other sectoral indices offered by the NSE include:

  1. Nifty Auto Index 
  2. Nifty Consumer Durables Index
  3. Nifty Healthcare Index
  4. Nifty IT Index
  5. Nifty Media Index
  6. Nifty Metal Index
  7. Nifty Oil and Gas Index
  8. Nifty Pharma Index
  9. Nifty Private Index
  10. Nifty PSU Bank Index
  11. Nifty Realty Index

What are thematic funds?

As per SEBI’s classification of mutual funds, a thematic fund invests a minimum of 80% of its total assets in equity and equity-related instruments of a particular theme. It is an open-ended equity scheme following a specified theme. SEBI has sub-categorised thematic funds under the broader category of equity schemes.

A thematic fund, for example, a consumption fund, will invest a minimum of 80% of its total assets in the shares of various companies that are a part of the consumption theme. The consumption theme is comprehensive and covers companies from multiple sectors/industries such as FMCG, restaurants, liquor, automobiles, electronics and consumer durables, garments, paints, telecom, entertainment, retail chains, etc.

Fund/Index1 year3 years5 yearsSince inception
Commodities Theme Category Average65.13%15.55%14.72%17.02%
Nifty Commodities Index (Benchmark)80.59%16.29%16.10%9.75%
Consumption Theme Category Average65.13%15.55%14.72%17.02%
Nifty India Consumption Index (Benchmark)32.07%8.80%12.55%15.25%
Digital Theme Category Average65.13%15.55%14.72%17.02%
S&P BSE IT Index91.42%30.68%24.27%19.14%

As seen from the above table,

  • Except for performance since inception, the commodities theme category average returns have consistently underperformed the Nifty Commodities Index (benchmark) in the last one, three  and five years periods.
  • The digital theme category average returns have consistently underperformed the S&P BSE IT Index (benchmark) in the last one, three  and five years periods.
  • The consumption theme category average returns have consistently outperformed the Nifty India Consumption Index (benchmark) in the last one, three  and five years periods.

Thematic indices offered by the NSE

Mutual fund houses launch thematic mutual fund schemes with various indices offered by the NSE and BSE as the benchmark. Some of the thematic indices provided by the NSE and some of the thematic mutual fund schemes launched by AMCs include:

Thematic IndexThematic Mutual Fund Scheme
Nifty Commodities IndexTata Resources and Energy Fund
SBI Magnum Comma Fund
ICICI Prudential Commodities Fund
Nifty Infrastructure IndexNippon India Power and Infrastructure Fund
Aditya Birla SL Infrastructure Fund
L&T Infrastructure Fund
Nifty MNC IndexICICI Prudential MNC Fund
UTI MNC Fund
Aditya Birla SL MNC Fund
Nifty 500 Shariah IndexTata Ethical Fund

Some of the other thematic indices offered by the NSE include:

  1. Nifty 100 ESG Index
  2. Nifty SME EMERGE Index
  3. Nifty CPSE Index
  4. Nifty Corporate Group Indices
  5. Nifty Energy Index
  6. Nifty India Consumption Index
  7. Nifty PSE Index
  8. Nifty Services Sector Index

The Differences : Sector funds Vs Thematic funds

Some of the differences between a sector fund and a thematic fund include:

  1. Scope of the fund
    The scope of a sectoral fund is narrow as compared to a thematic fund. A sectoral fund, for example, an auto fund, will cover companies only from the auto sector like Maruti, Bajaj Auto, Escorts, etc. But, a thematic fund, for example, a consumption fund, will cover companies from multiple sectors, including the auto sector. 
    Some of the sectors/industries covered by a consumption fund include automobiles, FMCG, electronics and consumer durables, garments, paints, telecom, entertainment, retail chains, etc.
  2. Concentration risk
    A sectoral fund has concentration risk as it has companies from a single sector. For example, a commodity fund will be subject to the commodity cycle. During an economic downturn, the demand for commodities goes down, leading to a fall in commodity prices. The commodity price fall affects the share prices of commodity companies negatively and thus negatively impacts the returns of a commodity fund.
    On the other hand, during an economic boom, the demand for commodities increases, leading to a rise in commodity prices. The commodity price rise positively affects commodity companies' share prices and thus impacts the returns of a commodity fund positively.

    Hence, the timing of entry and exit from a sectoral fund is critical. But, timing a commodity supercycle and accordingly getting in or exiting a sectoral fund is very difficult.

A thematic fund covering companies from different sectors offers much more diversification than a sectoral fund. Hence, a thematic fund is not subject to concentration risk like a sectoral fund.

For example, a consumption thematic fund can cover companies from various sectors/industries such as automobiles, FMCG, electronics and consumer durables, garments, paints, telecom, entertainment, retail chains, etc.

All the companies from the above sectors are not correlated to each other. Hence, there is no need to time the entry and exit from a thematic fund like a sectoral fund.

FeatureSector FundThematic Fund
SEBI investment mandateHave to invest a minimum of 80% of its total assets in equity and equity-related instruments of a particular sectorHave to invest a minimum of 80% of its total assets in equity and equity-related instruments of a particular theme
Coverage scopeNarrow scope restricted to companies of a specified sectorBroad scope covering companies spanning multiple sectors related to a common theme
Risk involvedVery high risk as it takes concentrated bets on a specified sectorHigh risk as it can take diversified bets on multiple sectors
DiversificationOffers no diversification beyond one sectorOffers diversification among various sectors
Who should investAn investor who understands a specified sector, for example, pharma, and is willing to take exposure to it can invest.An investor who understands a specified theme, for example, digital, and is willing to take exposure to it can invest.
VolatilityThey can have very high volatility as one adverse event can affect all the companies in the fund.They have relatively less volatility as they are more diverse with companies from different sectors. As a result, the underperformance of one industry can be covered by the outperformance of other sectors.

The risk profile of sectoral and thematic funds as compared to diversified equity funds

Sector fundThematic fundDiversified equity fund
Risk profile: The risk profile of a sectoral fund is higher than a diversified equity fund.The risk profile of a thematic fund is lower than that of a sectoral fund but higher than that of a diversified equity fund. The risk profile of a diversified equity fund is lower than that of a sectoral fund and a thematic fund.
Scope: A sectoral fund’s scope is narrow, and it is subject to concentration riskA thematic fund, although it can cover companies from multiple sectors as compared to a sectoral fund, still its scope is limited as compared to a diversified equity fund.A diversified equity fund can cover companies from all sectors as long as they fit within the fund’s selection criteria.

So, suppose we have to rank the three fund categories in the order of risk. In that case, sectoral funds are the riskiest, then come thematic funds, and finally diversified equity funds as they have relatively lower risk than the other two.

An investor wanting to invest in sectoral funds or thematic funds or both should limit their equity portfolio exposure to these funds at around 10% due to their highly volatile nature.

Things to Keep in Mind Before Investing in Sector and Thematic Funds

It is recommended that you consider the following factors before investing in the sector or thematic funds:

  • It is a good idea to build a balanced portfolio of conventional funds before investing in sector or thematic funds. Because sector and thematic funds are known for their higher risk and volatility, any investor who invests more than 10% is taking a big risk.
  • Sector and thematic funds are best for people who have a deep expertise of a certain business or subject.
  • Because sector funds are cyclical, it's important to pay attention to the timing of your exits while investing in them.
  • Don't base your selection on past success when investing in a sector or thematic fund. Instead, take a hard look at the industry or theme's potential.

Should You Invest In Sector And Thematic Funds?

Essentially, you are playing the role of the fund manager, so you need to understand the theme or sector thoroughly. The investment's timing must be carefully considered. It's pointless to enter an industry or theme that has already been delivered. In order to receive the best returns, the exit timing must also be carefully managed.

While sector and thematic funds can provide significant returns when they are performing well, they can swiftly destroy your profits if they are not performing well. The following table compares the performance of several sector fund categories to diversified multi-cap equity funds throughout time.

            Sector funds versus diversified equity funds
 1-year returns (%)3-year returns (%)5-year returns (%)10-year returns (%)
Diversified equity funds21.7414.5718.509.84
Infrastructure funds29.5915.3617.194.22
Banking funds25.7115.9715.4013.39
FMCG funds22.1815.4216.7218.41
Pharma funds-9.393.8515.7915.27
Technology funds10.324.1815.988.61

The Takeaway

There's nothing wrong with buying sector and thematic funds as long as you understand the risks and rewards. All you have to do is keep them within reason. Don't set unrealistic goals for yourself, and retain a mental stop loss for the worst-case scenario. Consider these sector and thematic funds as an opportunistic play on market excess returns. They are not a replacement for a well-diversified mutual fund portfolio!

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FAQs

Q1: What precisely is the difference between thematic and sector funds?

A1: Sector funds invest in specific industries or sectors, such as banking, pharmaceuticals, information technology, real estate, and energy. On the other hand, thematic funds invest in stocks that are tightly focused on a single business opportunity. These may resemble sector funds, although they may include multiple sectors.

Q2: Why are thematic funds so risky?

A2: Thematic funds are one of the riskiest types of mutual funds. When a portfolio is structured around a theme, the range of investment options is limited. It would have to invest solely in equities associated with that theme. So you have a portfolio that is semi-diversified.

Q3: Is it wise to invest in sector funds?

A3: Sector mutual funds allow investors to put their money into industries with a lot of room for growth. These mutual funds offer significant returns, but only if the timing of the investment is exact. It is critical to invest in sector-specific funds at the right time. Exiting the fund becomes critical as well. 

Q4: I'm not sure how many sector funds I should have.

A4: Hold one fund in each of the three categories: large, mid, and small cap. As a general rule, you should not have more than two funds in the same theme/market cap. With just one fund, you'll do exceptionally well. Extend it to two if necessary, but not beyond that. 

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