What about sector or theme-based mutual funds?

Sectors and themes are becoming more and more popular in the investing universe today than they were a few years ago. With diversified mutual funds being vanilla (boring to a lot of people), sector and themes add an element of appeal to the investing process. Let’s focus on things to watch out for when investing in these products. But first, let’s understand what they are.

Theme/sector funds are mutual funds/ETFs which provide investment exposure to a particular sector or a theme. They were originally developed for investors to make directional calls on specific sectors or themes without having to pick a stock.

Picking a stock has two types of risk - sector risk and stock risk. Even if the sector is booming - there may be instances where the particular stock may not be worthy of investing due to its attributes. Sector funds, therefore, are excellent at removing stock-specific risk completely from investing. When an investor wants to play in the banking sector - he does not have to decide whether to buy HDFC Bank or an SBI. He can buy the sector fund (active or passive) and get exposure to the sector as a whole (removing the risk of picking the wrong stock).

What are the differences between themes and sectors? Sectors refer to fund that invest in stocks that a part of a particular industry group or sector (like Pharma, Banking, Infrastructure, among others). Thematic funds are slightly broader (like Rural consumption, ESG, Consumption, Energy, among others).

What should investors keep in mind before investing in sectors and themes?

Sector/themes tend to be more volatile and risky

Sector funds tend to be a lot more volatile than diversified equity funds. Diversified funds have multiple sectors where movements between them tend to balance out each other. In sector funds, underlying stocks tend to move together - thus increasing volatility by a large margin.

Most investors should re-consider using sector funds as long-term investment opportunities because of the risk associated with them. Diversified funds tend to be most effective for long-term wealth creation combined with other asset classes.

Importance of timing in sector funds

Sector funds tend to be popular after strong past growth which may be too late for buy. For example - Pharma funds are not getting popular due to the recent run-up in the sector. Investors looking to buy into the strategy today may be disappointed in the future since markets tend to be efficient and forward-looking. However - investors looking to take a call on valuations or future expected growth may receive a call on a sector or a theme. Maximizing gains from an industry or a theme involves some level of market timing - something very few investors are good at.

The psychology behind buying sector/themes

Sector funds tend to be popular just when everyone is talking about them. What this means is that most people who end up buying are buying at peak valuations - which can be harmful to long-term investors. It’s therefore crucial for investors not to chase high past returns or popularity of a particular sector or a theme. Most investors should be okay with diversified mutual funds. They offer the best long-term opportunities on risk and return basis.

Sector funds can be seen as in-between stocks and mutual funds

Sector funds are better seen as in-between stocks and mutual funds. Investors looking to take a call on the short - medium-term growth of a sector/theme without having to buy a particular stock could use sector funds in the right way. In conclusion - Investors should be wary before buying into sectors and themes.

They tend to be more volatile and require some element of market timing to maximize their effectiveness in the portfolio. Most investors are better off in diversified mutual funds for their long-term needs.