What Are Thematic Mutual Funds and How Do They Operate

Financial markets are constantly evolving with the changing macroeconomic landscape – opening doors to newer opportunities for investments and potential growth. Over the past decade, the Indian asset management landscape has seen significant development in the thematic mutual fund space, allowing investors to focus on emerging sectors, structural trends or long-term economic themes.

What are Thematic Mutual Funds?

In simple terms, a thematic mutual fund is an equity-oriented scheme that builds its portfolio around a specific investment theme. According to the categorisation norms laid down by the Securities and Exchange Board of India (SEBI), these funds are mandated to invest at least 80% of their total assets in equity and related instruments that fall within their defined theme.

It is helpful to view a "theme" as something much broader than a single industry. For example, an infrastructure-themed fund doesn't just buy shares in construction firms; it can technically include cement manufacturers, steel producers, logistics players, and even power companies.

The idea is to potentially capitalise on the collective momentum of various sectors that are unified by a single economic or social driver.

What is the mechanism of thematic mutual funds?

Thematic funds fundamentally operate by investing in the companies that are most likely to benefit from a particular trend. The fund manager identifies businesses from a variety of sectors that either contribute to or derive value from the selected theme.

For many investors, using an SIP calculator is a practical way to visualise how disciplined, long-term contributions to such thematic strategies may potentially compound over time.

However, a thematic fund’s performance is tied to how well the narrative plays out. If the theme gains traction as predicted, the fund can potentially outperform broader indices. That said, if the theme stalls or hits regulatory roadblocks, the high concentration may lead to periods of sharp underperformance.

Sectoral Funds vs. Thematic Funds

Although the terms are frequently used interchangeably by investors, there are clear distinctions between the two. A comparison of the two is presented in the subsequent table:

Key Characteristics of Thematic Funds

• Portfolio Concentration: Since the overarching theme of the stocks are under the same umbrella, the level of diversification is limited compared to standard diversified mutual funds or index funds.

• Agnostic to Market Cap: Market capitalisation is not a limiting factor for stock selection in thematic funds, provided they fulfil the criteria of the fund.

• Active Management: Many thematic funds are actively managed, where performance depends on the fund manager’s ability to select companies aligned with the theme. However, thematic exposure may also be available through passive funds or ETFs tracking a theme-based index.

Benefits of Thematic Funds

• Growth: Since these are targeted funds, there is a potential of outperforming the broader market, considering the theme shows positive developments.

• Tactical Portfolio Overlay: Investors with a strong core portfolio in large cap stocks and diversified assets may consider thematic funds as a satellite allocation to seek additional exposure to a specific trend, while accepting higher concentration risk.

• Broad Cross-Sectoral Reach: These funds maintain a keen focus while offering a more balanced perspective than pure sectoral funds, as themes can be wide-ranging.

Risks Associated with Thematic Funds

Conversely, thematic funds come with their own set of risks:

• Concentration Pressure: The fund's dedication to a particular narrative prevents it from diversifying into unrelated sectors. If the thematic narrative faces challenges, the fund may face unfavourable outcomes, especially over the short term.

• Restrictive Mandates: Fund managers are constrained by the fund's overarching theme and are unable to diversify into funds that do not comply with the theme's legal mandate.

• Extended Gestation Periods: It can take a long horizon for structural changes to potentially play out. This requires a level of patience that some investors may find difficult to adhere to.

Who should consider investing in thematic mutual funds?

Thematic funds are typically not considered to be suitable for individuals who are just beginning their investment journey or those looking to build a core portfolio. They may be more aligned with investors who have an understanding of market cycles and emerging themes.

Additionally, investors must have the risk appetite to hold on to investments for a longer period through intermittent volatility, considering the sensitivity of thematic funds to macroeconomic factors.

Conclusion

Thematic funds sit between the highly concentrated sectoral funds and the widely diversified equity funds, thus offering investors a chance to potentially capitalise on upcoming narratives such as ESG and digitisation. These funds may offer the potential for higher returns if the theme performs well over time, but they can also underperform diversified funds for long periods if the theme weakens.

FAQ

1. What are the practical differences between thematic and sectoral funds?

Sectoral funds focus on a single industry, such as finance, whereas thematic mutual funds invest in a variety of sectors that are connected by a broader trend, such as infrastructure or rural consumption.

2. Are thematic funds an appropriate choice for a novice portfolio?

Typically, no. Their specialised focus and high interim volatility render them more appropriate for experienced investors who already have a well-diversified core portfolio.

3. How can I determine whether a particular theme will be successful?

Evaluate macroeconomic data, changes in government policy, and evolving consumer behaviour. Always consult a professional financial advisor before investing.

4. Is it feasible to participate in these funds through a systematic investment plan (SIP)?

Many thematic funds allow SIPs, which aim to leverage disciplined investing and rupee cost averaging. An SIP calculator can help investors estimate how periodic investments may potentially grow over time, but the output is only illustrative and does not guarantee actual returns.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.