The cost of chasing trends with sectoral and thematic funds

Why are thematic and sectoral funds so popular?

In recent years, thematic and sectoral funds have captured investor interest by offering exposure to focused, high-growth market areas. Unlike traditional equity funds, they target companies in sectors with a common theme (e.g., environmental and social governance, or ESG, and defence) or companies in a specific sector (e.g., banking and infrastructure).

On the one hand, investors are drawn to thematic and sectoral mutual funds for their ability to capitalise on big market trends such as electric vehicles (EVs) and artificial intelligence (AI), or policy-driven opportunities such as defence and solar energy.

On the other hand, as the Securities and Exchange Board of India (Sebi) allows only one scheme per category, asset management companies (AMCs) are pushed to focus on differentiated thematic products that will appeal to investors seeking unique opportunities.

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Where do investors go wrong?

Past performance analysis is the most common mutual fund selection approach retail investors adopt. Many of them succumb to the appeal of sectoral funds after seeing their recent success but may have entered the market when a sector’s growth cycle is nearly complete.

Sectoral funds are inherently cyclical, fluctuating dramatically over time due to macroeconomic factors. A sector that has demonstrated strong growth in recent years may have peaked, leaving new investors vulnerable to declining returns as the cycle reverses.

This cyclic phenomenon extends beyond investor behaviour to fund launches. AMCs often introduce thematic funds at market peaks driven by prevailing sector enthusiasm. Motilal Oswal (fund 1), Aditya Birla Sun Life (fund 2), and Groww (fund 3) launched their defence funds when the sector was reaching its peak. These funds, launched amid high sectoral valuations, have struggled to deliver returns since.

Many retail investors fail to recognise that each industry operates on its own business cycle, independent of the broader market. For instance, while the technology sector might be experiencing vigorous growth, the manufacturing sector could be in decline. Understanding these sector-specific cycles is pivotal for making informed decisions.

Also, while investing in thematic and sectoral funds, investors may unknowingly over-allocate to the same sector. For instance, investors in defence mutual funds often already have defence sector exposure through their diversified equity funds.

Further, retail investors often concentrate their portfolios heavily on trending sectors, particularly during bull markets. This overexposure can lead to substantial losses when sector-specific risks materialise.

Complex factors like technological advancements and shifting regulatory policies can also permanently alter a sector. Hence, what worked in previous cycles may not apply to future ones, especially in rapidly evolving sectors.

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Avoiding sectoral and thematic investment pitfalls

Seasoned financial advisors recommend limiting sectoral and thematic funds to your satellite portfolio, allocating no more than 10-15% of your total investments, to contain potential downside risk while still capitalising on specific market opportunities. The core portfolio should remain anchored in diversified equity funds that provide stable, long-term growth potential.

As investment success requires understanding complex factors such as business cycles, regulatory frameworks, and market dynamics, sectoral and thematic fund investments are best suited for savvy investors with a high-risk appetite, deep market knowledge, and analytical capabilities.

For investors who are not seasoned or prefer not to engage in such detailed analysis, it is advisable to consult a qualified financial advisor who can help navigate these complex investment decisions.

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Prashant Joshi is co-founder and partner, and head–family office and private wealth, at Upwisery.