Thematic Mutual Funds - A Complete Guide

Every now and then, we hear headlines like the government announcing a massive rural infrastructure plan or renewable energy projects expanding across the country. These stories often make us wonder whether these areas have strong growth prospects and whether investing in them could be profitable. If that thought has ever crossed your mind, Thematic Mutual Funds may be the answer you’re looking for. These funds allow you to invest in a broader story, or rather, a ‘theme’, meaning your money is spread across several sectors that all benefit from the same underlying idea. Let’s understand what thematic funds are and how you can invest in them.

What are Thematic Mutual Funds?

According to SEBI, Thematic Mutual Funds are types of equity funds that invest at least 80% of their assets in stocks of companies sharing a common trend rather than belonging to a single industry.

For example, let’s say an AMC launches a housing fund. The idea behind this fund is to catch the growth opportunities in the housing and real estate development scene. This fund can include stocks from multiple sectors that contribute to or benefit from this theme. It can invest in banks from the financial sector, since they provide home loans and finance projects. It could also hold shares of cement and steel producers from the construction sector, and it could also include energy companies, since power supply is a part of the housing theme.

Similarly, a thematic fund can focus on investing only in companies that are environmentally, socially, and governance compliant. The main idea here is to invest sustainably, which is why managers select companies that not only generate profits but also have a positive long-term impact on society and the environment.

Sectoral Funds

When you’re reading about thematic funds, you’ll notice that they are often written as ‘Thematic/Sectoral’ funds. This is because both categories fall under the broader umbrella of equity mutual funds. They are related, but should not be confused as the same thing.

Sectoral funds invest only in one specific industry, for instance, a banking and finance fund will only focus on the financial sector. Similarly, an IT fund will invest only in tech companies, and its returns will depend on how well the IT sector performs. Thematic funds have a much bigger universe because they invest across multiple sectors. This makes them more diversified and hence, less risky compared to sectoral funds. That said, these funds are still considered high-risk investments not just because of the equity-heavy focus but also because their performance depends on how the chosen theme plays out. That’s why a Mutual fund advisor may only recommend these funds if you have a higher risk tolerance and want to capture opportunities.

How do Thematic Funds Work?

Structurally, Thematic Mutual Funds work similarly to other mutual funds. They are professionally managed investment vehicles which pool money and invest it in a portfolio of well-researched securities aligned with the fund’s philosophy and objectives. In this particular case, SEBI mandates that at least 80% of the pooled assets must be invested in companies connected with a particular theme. Once the theme is selected, the manager selects the stocks that fit the theme and showcase strong long-term potential.

Taxation of Thematic Mutual Funds

Since over 65% of the fund is allocated to equities, thematic funds enjoy equity-like taxation. If you sell your thematic fund units within one year of purchase, the gains are classified as short-term capital gains and taxed at 20%. On the other hand, if you hold your investment for more than one year, the profits are treated as long-term capital gains, which are taxed at 12.5% on LTCG exceeding Rs. 1.25 lakh in a financial year. A Mutual fund consultant can not only help you select the most suitable thematic funds but also lower your tax liabilities and optimise your post-tax returns.

How are Thematic Mutual Funds Different From Sectoral Funds?

Here are some ways Thematic Mutual Funds and sectoral funds differ from one another:

Pros and Cons of Investing in Thematic Mutual Funds

Let’s weigh the advantages and disadvantages of investing in Thematic Mutual Funds:

Advantages

• If the central theme performs well, thematic funds can deliver higher returns than the market in the long term.
• If you’re bullish on a certain idea and manage to enter at the right time, thematic funds can be a great way to ride that wave of growth.
• Selecting stocks individually to seize such trends can be a challenging and time-consuming task, but thematic funds save you that effort by giving you professionally managed exposure to a basket of stocks that are part of the chosen theme. Since investments are made across multiple sectors, they offer a degree of diversification.
• Certain themes allow you to align your investments with your personal beliefs. For example, if you’re a socially conscious investor, you can look into ESG funds that invest in companies following ethical and sustainable practices. Similarly, you can consider a renewable energy fund if you want to prioritise investing in companies working towards generating cleaner and greener power.

Disadvantages

• Even though thematic funds invest across sectors, they are still tied to a particular idea. Due to their concentrated portfolio, the total risk in the investment increases.
• Thematic funds tend to be cyclical, so investors need to have some knowledge and conviction about the chosen theme before investing. These instruments are generally more suited to seasoned investors who understand market cycles. That said, if you’re new to this style of investing, you can have a quick chat with our Online mutual fund advisor who’ll assess your risk appetite and goals to give you personalised recommendations.
• Since themes are cyclical in nature, there’s always a chance you might enter at a time when the theme is nearing its peak. In such cases, returns will likely not meet expectations. That’s why it’s important to invest only after understanding how the theme is positioned in the current market.
• To time the investment well, one needs to have a good understanding of market trends, government policies, and sectors that influence the theme’s performance.

Who Should Invest in Thematic Mutual Funds

Thematic Mutual Funds are not for everyone due to their high-risk nature. The following factors can help you decide whether these funds are a good fit for your profile:

Risk Tolerance

Thematic funds are not as diversified as other equity funds, like multi-cap or flexicap funds. They can experience wild swings depending on how that theme performs. They may suit you if you can handle high volatility for potentially higher long-term gains.

Investment Horizon

It takes years for a theme to deliver on its promised growth, so if you’re someone with an investment horizon of more than 5 years, you can consider thematic funds.

Market Experience

Market knowledge is essential to assess two key things. First, whether a particular theme has long-term growth potential, and second, when to enter at the right time. If you’re a beginner, you should strongly consider talking with a qualified Mutual fund advisor who can guide your entry and exit decisions to maximise your gains and manage risks.

How to Invest in Thematic Mutual Funds

Assess Goals and Risk Appetite

Even if you are bullish on a particular theme, you should only invest if your financial goals and risk appetite allow it. Thematic Mutual Funds are high-risk, high-reward investments. They can deliver strong returns when the theme gets going, but can also be quite volatile if the trend slows down.

Understand the Theme

Research which sectors the theme covers and how the roles they all play in the bigger picture. Every theme is driven by different factors, so understanding these is also important to estimate the long-term returns and risks involved.

Research Thematic Funds

There are many thematic funds available to investors. You must sift through these options and select the best-performing funds which also suit your financial profile. You should assess:

• AMC’s Reputation: Select an AMC known for its transparent practices. Most AMCs have policies in place for risk management and consistent performance. Another good measure of an AMC’s reputation is its AUM. Higher AUM correlates with higher investor trust.
• Fund Manager’s Track Record: Thematic funds are actively managed, and a manager’s skill plays arguably an even bigger role here than in more diversified funds. The manager’s ability to identify the right stocks and time entries and exits has a huge impact on performance.
• Expense Ratio: Funds charge a percentage-based fee to manage investors’ money, which, while small, can make a noticeable difference to your returns. Compare expense ratios across different funds, but remember not to compromise on the quality of management and performance.
• Past Performance: An analysis of performance history will give you an idea of how the fund has done across market cycles. Choose funds that have outperformed their benchmark consistently over different time periods.
• Risk-adjusted Returns: These metrics measure how much risk the fund manager took to deliver returns. Ratios like Sharpe or Sortino can help you understand if the fund is generating returns efficiently for the level of risk taken.

Consult a Mutual Fund Advisor

A Mutual fund advisor brings bags of experience to the table so they can help you analyse which themes are likely to perform well in the future. They also ensure that their recommended products are backed by solid fundamentals and that your investment aligns with your risk appetite and goals.

Diversify

Your asset allocation is determined by risk tolerance. Even for aggressive investors, it’s important to maintain diversification across different types of funds.

Monitor Regularly

Thoroughly review your portfolio at least once every six months to make sure the theme still has momentum.

Conclusion

Thematic Mutual Funds are types of equity funds that invest in a specific theme, such as ESG investing, green investing, or infrastructure development. A theme encompasses several sectors, so the concentration risk in a thematic fund, while higher than diversified funds, is lower than sectoral funds that go all in on a single sector. Thematic funds are best suited for experienced investors who have a high risk tolerance and a long-term investment horizon. If you believe that a particular theme has higher-than-market growth potential or follows a philosophy that aligns with your investment style and goals, then it may be worth considering.