Thematic & sector funds are all the rage. But recent returns mask the true risk.

It must have been the 20th time my sister had called to ask me this. As usual, I tried explaining the basics but was quickly interrupted this time.

“Don’t waste my time, just tell me where most people are investing.”

This was understandable. She had recently received a bonus and was in a race against time before her temptation to shop kicked in.

So, I looked at the data and found thematic and sectoral funds had the highest number of folios – a proxy for the number of investors. This category also became the largest in terms of asset size last month.

But before I give my sister a thumbs up or a thumbs down, let’s look at some ways to think about this space. This list was compiled with the help of experts.

Also read: How to buy a 3-bedroom apartment at 2 BHK prices: Secrets of stressed properties

Chasing returns: Any classic book on investing would advise you to buy low and sell high, but that’s easier said than done. There’s a pitch for a ‘defence scheme’ that says the Nifty Defence Index delivered a 206% return in the past 12 months. The eye-popping return makes for good marketing material, but investing in a theme or sector that has done well over the past three to five years is risky, as it’s probably time for the cycle to turn. A look at the past 10 years of data (WhiteOak’s data from 2014 onwards, for instance) shows there have been different winners and losers almost every year as far as themes and sectors are concerned. That’s not to say the buy-high-and-sell-higher strategy never works, but asset management companies will more often than not try to sell you something that has already done well in the recent past.

View Full Image

Churn attracts tax: In a sectoral or thematic fund, the investor has to decide on his own (or with his advisor) when to enter and exit a sector or theme. That’s a difficult task. Fund managers are best equipped to judge this since it’s their full-time job. But even if you manage to pull it off, you still need to sell your holdings and move to a different fund. “When you do this, you have to pay tax,” said Rukun Tarachandani, co-fund manager at PPFAS Mutual Fund. In this year’s Union Budget, the long-term capital gains tax was increased from 10% to 12.5% and the short-term capital gains tax from 15% to 20%, making mistakes and churn costlier.

Also read: Why this Singapore-based couple retains their Indian health insurance plan

Cost of being wrong: Data from FundsIndia shows that 11 sectoral and thematic indices underperformed the benchmark Nifty 500 by at least 100% in the past five years. The simplest explanation for this is that these funds have concentrated portfolios, so if a bet goes wrong, they underperform greatly.

Allocation size: Let’s assume for a moment that you got everything right. You timed your entry perfectly, chose the right fund, and got decent valuations. But even that’s not enough if you don’t have sufficient allocation. “Even if you get everything right, you are likely to be under-allocated,” said Jiral Mehta, senior research analyst at FundsIndia. And if you allocate more to such funds, the cost of going wrong is much higher.

Also read: Children abroad? Why parents need a power of attorney

When to exit: This might be the most important point. “I’ve seen fund managers tell investors to invest in a theme but never when to exit it,” said Rukun Tarachandani, a fund manager at PPFAS. Exiting an investment at the right time is arguably harder than investing at the right time.

Choice paralysis: There are 179 sectoral & thematic funds available in India. ELSS funds, the second-largest category within equity funds, has 42. Deciding which one to invest in is no easy task.

In conclusion, that’s a thumbs down from me, sis.