Read this before you invest in a thematic fund

By Larissa Fernand |  23-08-21 | 

Thematic funds are all the rage, not just in India but across the globe. But don’t be too eager to bite the bullet.

Let me clear the air between a theme and a sector.  A sector fund will invest predominantly in one single sector, but a thematic fund will do so across multiple sectors linked by an underlying theme. Thematic investing focuses on long-term trends that envelope many sectors. So the Consumption theme would include numerous sectors such as FMCG, consumer durables, textiles, and leisure. Same for the Healthcare theme (pharma, biotechnology, medical equipment) and Financial Services (banking sector, insurance, NBFCs), and so on.

Ben Johnson, Morningstar’s director of global ETF research, likens investing in thematic funds to placing a trifecta bet at the horse track. A trifecta is a parimutuel bet placed on a horse race in which the bettor must predict which horses will finish first, second, and third, in the exact order.

In the case of a trifecta bet, you are trying to get three things right. When you apply it to investing, you are implicitly betting that you are:

  1. Picking a winning theme. Is the theme real? Is it durable?
  2. Picking a fund that is well-placed to harness that theme. Does the fund own stocks that are positioned to capitalize on it in a meaningful way - today, tomorrow, and well into the future
  3. Making a wager that valuations are not already priced in the theme's potential. This is perhaps the most important question: are the valuations right? Are these compelling values? Or, has the market already priced in much of investors' enthusiasm about this theme?

Picking a theme.

Investors rarely act on a well thought out strategy. They simply gravitate towards the flavour of the year, which means that they are already behind. Individuals who invest in today’s winners are “buying backward”. They enter the fund at its peak, leaving little leeway for the investments to run. And then they have a horrible investing experience.

Such focused funds can shoot out the lights one year and be a loser the next because they essentially lack the diversification to ride out trouble. One should never commit the grave error of investing in a thematic/sector fund simply because it has had a great run that year. Which brings us to the next point.

Entering at the right time.

On the surface, the theme may seem like a great attempt to capitalize on a seemingly inevitable long-term trend. It may seem plausible that stock prices don’t fully reflect those trends, given the widely held perception that the market is focused on the short term.

Even if a trend plays out as expected and a fund is well-positioned to take advantage of it, that won’t necessarily translate into market-beating returns. The market may have already priced in that trend. Macrotrends aren’t a secret. If you know about it, the odds are so does everyone else.

The key is to identify underappreciated trends, which is no easy feat. The relationship between earnings growth and stock returns is tenuous at best, as faster-growing companies tend to trade at higher valuations, which offsets the benefit of that growth.

What matters is growth relative to the market’s expectations, not the absolute level of growth. It is difficult to forecast the impact of a trend on businesses more accurately than the market. Doing so requires more than just an understanding of the macro story, but also understanding what the market is currently pricing in and how the competitive landscape might evolve. That’s a tall order.

Picking a fund.

It’s necessary to look beyond the fund name to understand the exposure the portfolio delivers. Not all thematic funds will effectively profit from the growth of their targeted trend. It’s tempting to take for granted that the stocks are positioned to benefit significantly from the targeted theme. After all, fund providers wouldn’t be doing their jobs if they delivered a portfolio incongruent with the fund’s mandate.

Being a thematic or sector fund will ensure that the portfolio is narrow. But all portfolios are not equal. Not in the stocks selected, the weightage to the top 5 stocks, or the number of stocks.

Some may be pretty diversified to negate the risk, while others may decide to go all in with some really bold bets. Undoubtedly, it creates considerable upside potential for those fortunate enough to find one of the few winners. The key word being potential; the risk hovers.

Check the expense ratio. It could be pretty steep. 

So should you?

Sector funds can be useful tools for investors with strong views who want to give a tactical slant to their portfolio. In areas of the market you are confident about or see an upturn in the future, you can employ a sector strategy to increase exposure. But if you invest in them, you need to understand exactly what you’re buying — and how much risk is involved.

Unlike a regular equity diversified fund, the fund manager does not have much latitude if the sector falls from favour. And the volatility can be unnerving. Be geared to take a hit if your call goes wrong or takes a long, long time to fructify. And, as long as you are invested, don’t let hair-raising volatility disturb you.

According to Ben Johnson, based on historical performance, it is evident that much of investors' enthusiasm tends to be priced in by the time that there are one or more thematic funds targeting a specific trend, a specific theme that are brought to the market. He suggests that investors enter with eyes wide open. But they can consider these thematic funds around the corners of their portfolios. Maybe if they've got some funny money set aside to take a more speculative position.

The other role I think they could potentially play for an investor's portfolio is as a single-stock substitute. So, investors might buy into a particular theme, but they might not have the resources or the inclination to really dig in and understand what are the best-of-breed stocks that are going to capitalize on that theme. So, if you like the theme but you don't know which stocks to pick, you might be well served to outsource that work either to a fund.

Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.

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