With mutual fund houses running out of mainstream equity categories for new funds, they have been rolling out many sector and thematic funds. Such funds take concentrated bets on a single sector or on a theme consisting of a few sectors. In end-November 2024, 190 of 481 open-end equity schemes open for business were thematic funds and this was the most popular category of equity funds.

Sector and thematic funds can deliver a big kicker to your equity portfolio when they click. In the last five years, the best-performing thematic funds managed a 25-31 per cent CAGR (compounded annual growth rate), against the 15 per cent return on Nifty50.

But these returns were pocketed only by investors who identified the right themes, selected the most promising funds within them and entered them at the right time. Doing all this requires skills of a high order.

Know what you’re buying

Are you tempted to buy into an ‘Opportunities’ fund because two of the top-performing thematic funds in the last five years have been from this genre? Before taking the plunge, you need to understand what kind of opportunities you are hoping to play, because there’s no standard definition of this theme. If you ask five MF experts what an ‘Opportunities’ fund is, you may get six different answers!

ICICI Prudential and Franklin India run Opportunities funds that look to exploit special situations in stocks or sectors arising from corporate actions, government policy, regulatory changes, companies going through a rough patch etc. But Kotak Equity Opportunities Fund bets on companies and sectors with strong growth potential. The portfolios of these thematic funds, despite their similar names, are very different.

For instance, in November 2024, ICICI Pru Opportunities Fund was 80 per cent invested in large-caps with a 38 per cent weight in financial stocks, and most other sectors bagging small weights. But Kotak Equity Opportunities Fund was 35 per cent invested in midcaps and had weights of 17-19 per cent each in three sectors — financials, industrials and technology.

This is just one example of an outperforming theme where different managers have vastly differing ideas on how to play it. You will find vast differences in strategies, market-cap orientation and stock choices across thematic funds with broad mandates such as Quant, Manufacturing, Business Cycle and Innovation.

Therefore, before betting on a thematic fund with a nice-sounding label, go through its Key Information Memorandum describing its precise strategy. Read recent factsheets and portfolios to see what types of stocks it owns.

Specialised skills

When betting on sector or theme funds, many investors think that any fund playing the theme will do to earn big returns. They believe that if a Transportation and Logistics Fund from one AMC has delivered stellar returns, another will do just as well, and ditto for Manufacturing or Consumption.

The reality, however, is different. While the top-performing consumption funds (Nippon and SBI) delivered a 24-25 per cent CAGR in the last five years, the bottom performers managed only 17-19 per cent. Returns on Manufacturing-themed funds range from 27 per cent CAGR to 20 per cent.

This underlines the fact that you should buy thematic or sector funds only if you have the skills to distinguish between a well-constructed portfolio in the theme and a poorly-constructed one. Alternatively, you should know enough about the AMC/fund manager to bet on their ability to spot opportunities before the market.

Acing a sector or thematic fund is a specialised job. This is precisely why brokerage and AMC research teams run on sector specialisation. An AMC running a Business Cycle or Opportunities fund needs a top-down view of macros, to hop on to cycles ahead of the market. An AMC running a Pharma, Housing, Defence or Innovation fund needs bottom-up knowledge of specific companies in these themes. It is rarely that a single AMC or fund manager has both capabilities.

Typically, the bottom rankers in thematic funds have delivered very little alpha over flexi-cap funds. So, if you are not confident of running the above checks, you should stick to flexi-cap funds and avoid thematic bets.

Don’t buy into NFOs

Money managers know very well how to make an investment case for any sector or company of their choosing. Therefore, it can be tempting to invest in new thematic or sector funds at the New Fund Offer (NFO) stage, because of a slick presentation and convincing macro arguments for the theme.

However, in equity investing, folks who tell great stories may not be great stock-pickers; stock-picking geniuses may not be great orators. NFO investors may be disappointed to find that the first portfolio of their Innovation fund has old war-horses such as ICICI Bank, Maruti or Bajaj Finserv in its top holdings. Or that banking stocks, which are the bread and butter of every vanilla fund, are also top weights in Quant funds.

Relatively-new investors may also believe that a fund with NAV of ₹10 has a greater shot at delivering multi-bagger gains than one with NAV of ₹50. This is simply not true. Both funds will be investing in a theme at stock prices as of today. Your percentage gains from here is what matters, and not the number of units you own.

To home in on thematic or sector funds with promise, it best to avoid NFOs and look for seasoned funds that have demonstrated their ability to ace the sector or theme over a three-five-year period.

Tactical opportunities

Most sector and thematic funds offer tactical opportunities. That is, they deliver outperformance if bought before a theme becomes the market darling and sold when it is at the peak of its popularity. AMCs, however, like to launch thematic or sector NFOs when they are likely to get a good response, which is usually when a theme is already in vogue.

This again makes NFOs a bad time to bet on a thematic or sector fund and to take the timing call yourself. Apart from knowing when to enter a theme, you also need to have the conviction to parachute out when it is peaking out. This argues for investing only in sectors or themes that are non-cyclical, or those where you understand the cycle.

Check for portfolio overlaps

Many folks buy into sectoral or thematic funds thinking that they are adding something unique to their portfolio. But given that most Indian fund houses like to stick to the top 700 or so stocks in the market and are bound by liquidity constraints, portfolios of different funds with an AMC often end up borrowing heavily from each other.

Therefore, when buying into a thematic or sector fund, do check if its portfolio overlaps substantially with the large-cap, mid-cap, flexi-cap or index funds you already own.