Types of Mutual Funds :Thematic and Sectoral Mutual Funds Explained

There are various types of Mutual Funds like the following:        

1. Large Caps         
2. Mid Caps         
3. Small Caps
4. Multi Caps         
5. Large & Mid Caps etc.

Very rarely has there been enough discussion on Thematic and Sectoral Mutual Funds and we will try to rectify the same via this article.

What is a Thematic Mutual Fund?

1. A Thematic Mutual Fund as the name suggests follows a particular theme when investing.
2. A Thematic Mutual Fund can invest across various sectors that fall within one particular theme.
3. It is far more diversified than a Sectoral Mutual Fund since it is not restricted to any one particular sector.

What is a Sectoral Mutual Fund?

1. A Sectoral Mutual Fund as the name suggests invests only in one particular sector.
2. It is less diversified than a Thematic Mutual Fund since it is restricted to just one particular sector.

You may be able to understand this better by reading the following example.

   Think of Sports as a theme and various disciplines like Football and Basketball like sectors. Sports constitute both Football and Basketball but Football does not constitute Basketball and Basketball does not constitute Football.

In the same manner a Thematic Mutual Fund constitute various sectors but it is not necessary that various sectors fall within the same theme.

Thematic Mutual Fund and Sectoral Mutual Fund (Portfolio Allocation)

Thematic Mutual Fund

The table below mentions the top five holdings of Franklin Build India Fund (Thematic) as on 31^th January 2019

Holding	Category
State Bank Of India	Banks
HDFC Bank Ltd.	Banks
Indian Oil Corp Ltd.	Energy
Bharat Petroleum Corp. Ltd	Energy
NTPC Ltd.	Utilities

The picture below showcases the top five sectors it was invested in as on 31^st January 2019

As you can see from both the table as well as the picture, there is diversification in the holdings as well as the sectors. But what needs to be understood is that this diversification takes well within the realms of the theme (Infrastructure) and not beyond.

The Fund is not dependent on any one particular sector as such. This allows the Fund Manager to diversify risks which is extremely beneficial in case any one particular sector is going through a lean phase be it due to any new policy, market conditions or even regulatory changes like in the case of Pharmaceutical companies.

 

Sectoral Mutual Fund

The table mentions the top five holdings of Reliance Pharma Fund (Sectoral) as on 31^st January 2019

Holding	Category
Divi’s Laboratories Limited	Pharmaceuticals
Sun Pharmaceutical Industries Limited	Pharmaceuticals
Aurobindo Pharma Limited	Pharmaceuticals
Dr Reddy’s Laboratories Limited	Pharmaceuticals
Sanofi India Limited	Pharmaceuticals

As you can see all the top five holdings belong to the same sector.

1. With Pharmaceuticals based Mutual Funds, they are not only affected by domestic issues but also international issues.
2. A Pharmaceutical company in India has to take into account not only Indian regulations but also US regulations. This is because the US is the largest pharmaceuticals market, for Indian companies it makes up 40-50% of revenues.
3. Since Indian pharmaceutical companies form more than 1/3^rd of the US pharmaceutical sector, it is bound to attract greater inspection than the rest. 
4. This would require a more robust system on the part of the Indian Pharmaceutical companies in order to get the necessary clearance from the US FDA (Food and Drug administration).
5. Domestically Indian Pharmaceuticals suffer the dual setbacks of tax policies and price cap. The latter is due to the government wanting for cheaper drugs for the general public at large.

When are Thematic and Sectoral Funds launched?

It is generally seen that a Fund House would launch a scheme if it does not currently have one in a category. With SEBI not permitting a Fund House to have more than two schemes in the same category, the timing of the launch becomes all the more important considering that major business is expected and driven during a NFO.

With Thematic and Sectoral Funds though, the timing of them is very much dependent on the narrative that is propounded.

For example look at the launch dates of these IT based Mutual Fund Schemes

1. The reason for all these Funds being launched between 1998 and 2000 is because this was supposed to be the time of the IT boom in India.
2. The IT sector in 1998 contributed 1.2% to India’s GDP. The TIDEL Park, the then largest IT park in Asia was opened in the year 2000.
3. The Information Technology Act was also passed in the year 2000 which paved the way for legal procedures for electronics transactions and e-commerce.
4. All of the above factors did help in creating a positive market environment for the IT sector to boom and various AMC’s were not going to be left behind to milk this.
5. This therefore led to the launch of several IT based Mutual Fund Schemes in the space of just 2 years.
6. We have thus seen how the positive scenario around one particular sector helped in driving investors towards a particular Mutual Fund Scheme.

Now let’s look for an example where a beaten down sector allows for business to thrive in a particular sector driven Mutual Fund scheme.

Scheme Name	Launch Date
DSP Healthcare Fund	Nov-18
ICICI Pharma Healthcare and Diagnostics	Jul-18
IDBI Healthcare Fund	Feb-19
Mirae Asset Healthcare Fund	Jul-18

All of the above mentioned schemes were launched within a space of just 8 months.

The reason for this is that the Pharmaceutical sector as a whole was down, this therefore paved the way to build up a consensus that the past is behind us and things will only get better from here on.

As mentioned above, the timing of the launch of these types of schemes is very much dependent on the narrative that one wishes to believe.

How do Thematic and Sectoral Funds differ from other equity funds?

When it comes to Large, small, mid, multi, focused, large & mid-caps there is no restrictions of sectors. Sure there is restriction that comes with minimum investments in categories but not in sectors.

Large Cap Fund

For example a Large Cap Fund is required by law to invest a minimum of 80% in large cap stocks. But these large cap stocks need not be confined by sectors, meaning these large cap stocks can vary from banks to financial services to oil. The only restriction is that it should be a large cap stock.

Focused Fund

This is also the case with a Focused Fund, even though the Fund will invest only in a select number of stocks, it is not confined by the sectors. For example if a Focused Fund is limited by say only 25 stocks, it will not be restricted with the sectors that these funds belong. So it can swing with ease between various sectors as long as the number of stocks is not exceeded.

Sectoral Fund

With a Sectoral Fund, it is mandated to invest in that particular sector itself. This therefore does not allow it to take refuge in other sectors in case the sector it is currently invested in seems overvalued and due a correction.

Thematic Fund

With a Thematic Fund like say an Infrastructure Fund, a regulatory change in sector will have an effect on another sector too since they are all interlinked. For example a rise in cement prices will affect the real estate sector and thereby residential home prices.

Large & Mid Cap Fund

When you consider a Large & Mid cap fund, the minimum allocation in both the large and mid-sectors is 35% but the remaining 30% is entirely at the discretion at the Fund Manager. If the Fund Manager feels that the market is overvalued he/she can allocate the remaining 30% to large cap stocks, if however he feels there is further scope for growth then he/she can allocate the remaining 30% to mid-cap stocks.

The point of the above Large& Mid cap Fund example is to demonstrate the flexibility a fund manager enjoys when it comes to other equity funds that he/she does not have with thematic and sectoral funds so therefore they tend to be very high risk.

These Funds also tend to have an extremely high portfolio turnover ratio which is a determinant of the number of times a portfolio has been churned (movement)

Scheme	Turnover Ratio
ICICI Banking & Financial Services Fund	168%
SBI Banking & Financial Services Fund	175%
Taurus Banking & Financial Services Fund	114%

Source: Factsheet February 2019

A turnover ratio of over 100% means the portfolio has been completely changed over a period. The reason for such high turnover ratios with thematic and sectoral funds is because they tend to invest in businesses and sectors that are cyclical in nature, meaning the fund manager strives to enter at a low and exit at a high.

When should you Enter and Exit in Thematic and Sectoral Funds?

1. When you enter and when you exit a thematic and sectoral mutual fund is extremely vital. This becomes all the more important when it comes to a lump sum amount (Which should be avoided in most cases).
2. The reason for this is that these funds invest in cyclical businesses and ergo they themselves are cyclical funds. Take the example of real estate, you must have often read or heard the real sector is down or the real sector is booming. 
3. This is not to say that other equity funds do not have their own volatility but with thematic and sectoral funds, volatility is more frequent and at a higher level.
4. If you enter a thematic fund at a high and exit at a low then the entire exercise was futile. This means you cannot have a strict timeline with these funds, you cannot pick a year when you enter and a year when you exit. You would need to be extremely flexible and clever with your timing of entry and exit in these funds.
5. Keep in mind that the fund manager has his/her own strategy in place for entry and exits, if your timing does not align with that of the fund manager then that is a cause for major worry. 
6. You cannot predict the actions of the fund manager, that is beyond your control but what is within your control is your actions. So the prudent thing would be to leave timing completely up to the manager when it comes to the fund portfolio, you would still need to take your own calls with your own portfolio.
7. One of the biggest blunders that investors commit with these funds is looking at past returns and investing blindly expecting the markets to continue with its upward trend. When the markets slide investors exit with a heavy loss since they entered at a market high and exit at a market low.
8. This process of entering with greed and exiting with regret is very common and will continue as long as investors look at their portfolio with goals and not desire.

Should you invest in thematic and sectoral mutual funds?

1. These funds should never be a part of your core portfolio. Your core portfolio is the major chunk of your overall portfolio which would mean a rise or drop in them would be significant. Your core portfolio should only constitute moderately aggressive schemes and not very high risk schemes. The foundation of your portfolio cannot be so unstable and built on such shaky grounds.
2. The only reason to pick these schemes is when you are sure all other areas have been adequately covered and there is still scope for diversification. In an ideal world these schemes should rarely be part of most investor’s portfolio and yet when you look at the AUM some of these schemes have garnered, it is reflective of the returns chasing investor rather than the goal oriented investor.
3. It should not take up more than 10% of your entire portfolio and that too should have a valid reason. 

Another thing to ponder on is whether the scheme you would be venturing in to has been adequately covered or not. Take the case of A Banking and Financial Services themes fund.

1. We have taken the example of one scheme each from a Focused, Multi Cap, Large Cap and a Large & Mid Cap. The reason being schemes of these categories more or less form the core portfolio of the average investor (Large & Mid Cap in lesser proportion).
2. The contribution when it comes to Banking & Financial Services in these schemes is between 30 to 45 % which means 1/3^rd of the entire portfolio is invested in stocks of this sector.
3. When you compare a Banking & Financial Services with one of the above mentioned schemes, you would realize there is a high level of overlapping in stock selection. This would defeat the purpose of having a separate banking and financial services fund.
4. This is not to say that all funds of the above mentioned categories do take a higher proportion to banking and financial services but you would struggle to find a large or multi cap fund without exposure to HDFC Bank and Bajaj Financial Services.
5. This overlapping in stock selection defeats the very purpose of having a diversified portfolio.

Between the following, which scenario sounds more risk efficient?

A) Having a diversified portfolio with meaningful exposure to banking and financial services or

B) Having a strictly banking and financial services based fund?

In scenario A the fund manager can enter and exit as and when he feels it is needed but the same cannot be said of scenario.

    Your reason to invest in a thematic or sectoral mutual fund needs to be backed by logical reasoning like having no exposure at all or minimal in your portfolio and you have the requisite skills to understand the sector well enough to time your entry and exit or else you are better off without such funds.

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Disclaimer : While due precaution has been undertaken in the preparation of this article, The Mutual Fund Guide or any of its authors will not be held liable for any investments based on the above article. The above article should not be considered financial advice and has been published only for your perusal. Due credit has been given in case wherever required, in case you feel any part violates any rights then do get in touch with us and we shall get it duly removed.  

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