Understanding Thematic Funds for Beginners

Should You Jump on the Thematic Fund Bandwagon? A Reality Check

Your neighbour just bought a new electric scooter and won’t stop talking about how EVs are the future. Meanwhile, your WhatsApp group is buzzing about artificial intelligence changing everything. Suddenly, you see mutual fund advertisements promising to capture these “mega trends” through thematic funds. But before you get swept away by the excitement, let’s talk about what these funds really are and whether they belong in your portfolio.

What Exactly Are Thematic Funds?

Think of thematic funds like specialty restaurants. Just as a South Indian restaurant focuses only on dosas, idlis, and sambar, thematic funds invest only in companies related to a specific theme or trend. These could be technology stocks, healthcare companies, infrastructure firms, or even businesses tied to renewable energy.

Unlike diversified equity funds that spread investments across different sectors like a proper thali meal, thematic funds put all their eggs in one basket. They bet big on a particular story or trend they believe will drive future growth.

The fund manager doesn’t just pick any company. They look for businesses that will directly benefit from their chosen theme. For instance, an infrastructure theme fund might invest in cement companies, steel manufacturers, construction firms, and equipment makers all riding the same wave of infrastructure development.

The Appeal Behind Thematic Investing

1. Capturing Big Trends Early Thematic funds promise to help you ride major economic shifts. When the government announced the Production Linked Incentive scheme for manufacturing, several thematic funds focused on this opportunity. Similarly, when digital payments exploded during the pandemic, fintech-focused funds gained popularity.
2. Focused Exposure If you strongly believe in a particular sector’s future, thematic funds offer concentrated exposure. Instead of buying individual stocks and risking company specific troubles, you get a basket of related companies managed by professionals.
3. Professional Stock Selection Fund managers spend considerable time researching which companies within a theme have the best growth prospects. They handle the heavy lifting of stock analysis, financial modelling, and portfolio construction.
4. Easy Entry Point Rather than studying dozens of companies in a sector, you can gain exposure through a single fund investment. This makes it simpler for retail investors to participate in specific trends.

The Hidden Challenges You Must Know

1. Concentration Risk is Real When you put all your money in one theme, you’re essentially making a single large bet. If that sector faces headwinds, your entire investment suffers. Remember how pharma stocks struggled for years after their initial boom, or how metal stocks went through prolonged downturns.
2. Timing is Everything, and It’s Hard Thematic funds work best when you enter early and exit before the theme becomes overvalued. But predicting these entry and exit points is incredibly difficult. Most retail investors end up buying after the theme has already run up significantly.
3. High Volatility Comes Standard Because these funds lack diversification, they experience much higher price swings than regular equity funds. Your portfolio value can fluctuate dramatically, testing your patience and conviction.
4. Manager Dependency The fund’s success heavily depends on the manager’s ability to pick the right stocks within the theme and time the market cycles. If the manager makes poor decisions or leaves the fund, your returns suffer.
5. Expense Ratios Bite Harder Thematic funds typically charge higher fees than diversified funds. These costs become more painful when the fund underperforms, as there’s less diversification to cushion the impact.

When Thematic Funds Make Sense

Thematic investing isn’t inherently bad, but it requires the right approach and mindset. These funds work best as satellite holdings rather than core portfolio components. If you have a well diversified foundation of index funds or multi-cap funds, you can allocate a small portion perhaps 10-15% of your equity allocation to themes you strongly believe in.

The key is having genuine conviction about a long-term structural shift, not just following the latest market buzz. For example, India’s demographic dividend and rising consumption might justify exposure to consumption focused themes over the next decade.

You also need the temperament to handle volatility and the discipline to book profits when themes become overvalued. This isn’t easy, which is why most financial advisors recommend keeping thematic exposure limited.

Red Flags to Watch Out For

Be wary of thematic funds that launch during market euphoria around a particular sector. By the time a theme becomes popular enough to warrant its own fund, much of the easy money has already been made.

Also, avoid themes that seem too narrow or faddish. A fund focused on “blockchain and cryptocurrency stocks” might sound exciting, but it’s essentially gambling on a highly speculative area with limited listed companies in India.

Check the fund’s portfolio carefully. Sometimes, thematic funds stretch their mandate to include barely related stocks just to meet diversification requirements. This defeats the purpose of focused thematic exposure.

Making the Right Choice for Your Portfolio

Before investing in any thematic fund, ask yourself three questions. First, do you have a solid diversified equity foundation that can handle the volatility if your thematic bet goes wrong? Second, do you genuinely understand and believe in the long-term prospects of this theme? Third, are you prepared to hold for at least 5-7 years and handle significant interim volatility?

If you answered yes to all three, thematic funds can add value as a small part of your equity allocation. But if you’re looking for your first equity investment or trying to build a stable long term portfolio, stick with diversified multi-cap or index funds first.

To Sum Up

Thematic funds offer an interesting way to bet on specific trends, but they’re not suitable for everyone or every portfolio situation. They work best for experienced investors who understand the risks and have strong convictions about particular themes. For most investors, these funds should play a supporting role rather than taking centre stage in your investment strategy.

Start by building a diversified foundation, then consider adding thematic exposure once you have the base covered and the temperament to handle concentrated bets.