Regarding thematic funds, should you invest in them?

Andriana, a 40-year-old advertising executive, has been watching the equity markets set new highs month after month. She intends to invest in Equity Mutual Funds for her retirement. However, with all of the talk about Corona, the lockdown, and the need for better healthcare in India, she believes that healthcare is the area in which she want to invest. So she asked her buddy Ravi for advise on the best Thematic Funds to invest in relating to the healthcare industry.

Ravi agreed with Andriana and encouraged her to invest in an Equity Mutual Fund for her retirement planning because she has a long time before she needs the money. Recognizing that Andriana was not an expert investor, Ravi went over how Thematic Funds work and whether this was the best path for her. Let’s see what they talked about.

What Are Thematic Funds and How Do They Function?

According to SEBI regulations (the mutual fund industry’s regulator), a thematic fund invests at least 80% of its assets in companies that belong to businesses with a common filter or factor or a business’theme. From the standpoint of the kind of business or ownership pattern, the topic might be anything — infrastructure, PSU, MNC, etc. It could even be based on a common factor-based selection, such as a quantitative model or geographical bias (US equity, China equity, international equity, etc.).

Don’t confuse a sectoral fund with a thematic fund. Sectoral Funds concentrate their investments in a specific industry. Thematic funds, on the other hand, are those that have exposure to sectors or enterprises that share common development drivers or selection determinants.

What Are Investors’ Concerns When Choosing Thematic Funds?

Given the data presented above, you may be wondering why you don’t change the theme in your portfolio when it slows down or falls out of favour. At worst, you may lose a portion of it (like in the Financial Services example above from 2016), but you may still be lucky if it rebounds or if you can get away with a few scratches. The following are thematic funds’ areas of concern:

The Timing Problem

Figuring out when to enter and when to exit a theme can be challenging because the variables driving each theme, or even the sectors within that theme, are distinct and work under different situations. Furthermore, the duration of each subject (in terms of time) varies; some, such as consumption (or millennials), might endure years, whereas others, such as commodities, can lose traction in a matter of months.

Investing in Themes Is Expensive

Simply compare the typical expense ratio imposed by Thematic Funds to that of diversified funds such as Flexicap or Multicap category funds. From an investor’s perspective, this is the most expensive fund category, with thematic funds generally charging full charges (depending on size), typically in the vicinity of 2–2.3 percent p.a., whereas diversified funds are generally managed with an expense ratio range of 1.4–1.8 percent p.a., regardless of the outcomes.

Because every penny saved equals a penny earned, the higher the expense ratio, the smaller your earnings from the fund. While the higher risk assumed in thematic funds and the resulting need for additional focus by fund managers is an understandable argument, the expenses are significantly higher than in more diversified categories of funds that have delivered potentially better risk-adjusted returns over longer market cycles.

Size of the Opportunity and Expected Returns

It is difficult to predict how much the potential of a certain topic will return in the future, just as it is difficult to predict the moment of entry and leave. If you want to maintain a profit target, the estimated returns can differ from sector to sector and theme to topic; however, in diversified funds, a broad market estimate is easier to put based on overall economic growth.

Alternatively, if you have a specific investment horizon in mind, while diversified funds are simpler (the fund manager simply makes the most prudent decisions for you and adjusts the portfolio accordingly), thematic investing may present a challenge because the market cycle for different themes differs and may not fit your investment horizon.

Implications for Taxation

Assuming (and this is a big IF!) you can book profits and switch to another theme at the correct moment, you will have to pay capital gains tax each time you churn your portfolio. However, in a diversified theme, you sit back and enjoy the rise in markets and fund value until your goal return or time to redeem your investment arrives, and you will pay a significantly reduced (Long Term Capital Gains) tax rate under current Mutual Fund taxation laws.

Overlaps in Sectors in Any Rally

This is the most difficult because numerous themes might be active at the same time. So, how will you allocate your money across all themes? Of course, the fund management makes an informed judgement on your behalf in a diversified fund. Still, when you invest in thematic funds, you compel the fund manager to invest only in that theme, regardless of whether the theme is active or not!

Thematic Funds’ Performance

Let’s see how this plays out in reality and compare it to the performance of the last five years, which witnessed big political upheavals, technology advancements, and record highs and lows in markets around the world. During this time, the Nifty 50 Index produced 13.4 percent and went through at least two market cycles.

The length of the cycle and total return created by each theme are varied, as seen in the table above (reds indicate below-par performance & greens are better performance). This is precisely why timing is so tough for investors.

Also, take note of the last column, which displays the Standard Deviation of each investment, indicating the volatility (or risk) of each of these techniques (lower is better & higher is worse). Nifty 50 (or a diversified portfolio approach) was somewhere in the middle of the pack in terms of risk but the most consistent strategy in terms of returns, whereas other themes like PSU (Nifty PSE Index) or Consumption (Nifty India Consumption Index) have been quite inconsistent in performance and risk (volatility).

Let us use the MNC index and its performance as an illustration of the impact of standard deviation on thematic funds. 2003–2008 is remembered as one of the most significant eras of market bubble and subsequent recession. It is during this time when thematic concepts are most likely to be tested. MNC theme that boasts of top-quality enterprises with MNC lineage provided over 71 percent return throughout this brief span of around 2 years (Jan 06 to Dec 07) while decreasing 42 percent in the following 12 months. This decline marks a reversal of the previous two years’ advances (-1.05 percent ).

For someone who isn’t a market specialist, this is akin to Abhimanyu entering a Chakravyuh — entry is visible, but you don’t know when or how to depart! Simultaneously, the Nifty 50 (India’s headline equity index that provides diverse exposure across industries) outperformed. While it fell in percentage terms more, it grew significantly more and still generated a positive return (8.42 percent) at the end of this period. More crucially, for riskier and less popular issues like Infrastructure, as rapidly as the rally begins, so abruptly does it end.

Also, one potentially frightening feature of thematic fund investment to keep in mind is that more than 30% of thematic funds launched in the previous decade no longer exist, while many others continue to languish with low size and middling return records at best. These funds are often launched and flourish while the subject is in season, then wither away when the theme fades and investors begin to exit with diminishing performance. SEBI has to order fund firms to close or combine such small funds with larger (diversified) rivals in numerous circumstances. Their low survival rate serves as a reminder of the dangers that these themed funds face.

Should You Put Your Money Into Thematic Funds?

Ravi stated, and we agree, that you avoid themed funds unless you have at least a few hours per week available for study and market monitoring, as well as the ability to not just survive a 30% drop in your investment value (remember Financials theme in 2015–16). Even if you invest in the greatest Thematic Funds, this does not guarantee that you will make money. This manner, he claims, the fund manager will be able to consistently select the greatest chances and generate the best potential returns for new or conservative investors like her. She will not be at risk of a theme abruptly losing its flavour.

A more diverse strategy is a safer and more proven technique. As you can see from the preceding section, an investment in a more diverse portfolio performs better in terms of consistency, volatility, and speed of recovery.

Andriana is now completely sure about her investment strategy. Today, she takes the correct decision by investing in a diversified fund, such as a Flexi cap mutual fund, rather than chasing a theme trend until she has a better understanding of the market intricacies.