How investors can use thematic funds to boost portfolio returns

Synopsis

Thematic funds focus on investing in firms associated with particular long-term trends, aiming for potential alpha returns. They entail a greater concentration risk when compared to traditional diversified equity mutual funds. Therefore, investors must carefully time their entries and exits. It’s advisable for beginners to start with diversified equity mutual funds before venturing into themes. A gradual investment strategy over time is encouraged for thematic fund acquisitions.

Investors looking to generate alpha in their portfolios are increasingly betting on thematic funds, given the success seen in themes such as capital markets and defence in the recent past.

WHAT ARE THEMATIC FUNDS?

Thematic funds are those that invest at least 80% of their total assets in stocks linked to a particular theme. These are mutual funds or ETFs that invest in companies expected to benefit from a specific long-term trend or a theme, instead of a plain
vanilla equity fund.

Some of the popular themes among investors, and launched by fund houses in the last few years, include defence, capital markets, consumption, tourism, energy, digital, public sector undertakings (PSUs), and manufacturing. These funds can be either active or passive.

For example, an infrastructure fund will invest in stocks connected to the development of infrastructure in the country across sectors such as construction and cement, and may hold companies such as Larsen & Toubro, ABB and Honeywell Automation.

Read more: Can Shiprocket IPO deliver long-term growth for high-risk investors?

WHY ARE THEMATIC FUNDS RISKIER THAN DIVERSIFIED EQUITY MUTUAL FUNDS?
Unlike large-cap, flexi-cap and multi-cap funds, which invest in a diversified portfolio of stocks, thematic funds invest in
a narrower range of stocks and therefore carry higher concentration risk.

However, thematic funds are generally more diversified than sectoral funds such as IT or pharma funds and therefore
carry lower risk than them. If you invest at a time when economic conditions favour the underlying companies, these schemes can deliver high returns. However, any sudden adverse development in the economy that is not anticipated could affect the companies in the portfolio, potentially leading to losses in the near term.

Many times, themes may take longer to play out, while the broader market may continue to move higher, resulting in
prolonged underperformance.

WHICH CATEGORY OF INVESTORS SHOULD INVEST IN A THEMATIC FUND?
Financial planners believe that entry and exit timing are important in thematic funds to generate high alpha. Therefore, investors who can time both purchases and exits can consider investing in such funds.

First-time investors should avoid thematic funds and begin with diversified equity mutual funds. Once your core portfolio
is in place and you are looking to generate alpha and understand the associated risks, you may consider investing in one or two thematic funds. Investors can allocate to thematic funds as part of their satellite portfolio, while keeping the core portfolio invested in a mix of diversified equity mutual fund schemes.

HOW SHOULD YOU INVEST IN THESE THEMES?
If investors believe certain events are likely to unfold over the next year that could benefit a theme, they can use a staggered approach to investing. If they believe the theme can perform at any time, they may opt for a one-time investment. Unlike diversified funds, where investors can simply buy and hold, thematic funds may warrant a more measured approach. Investors can make small lump-sum investments or stagger their purchases on market dips over a relatively short period of three to
six months.