How to invest in sector or thematic funds

When we talk about diversification, we try to place the eggs in different baskets. Particularly when investing in equity mutual funds (MF) our attempts to diversify is fraught with danger as we might meander off from our target and risk profile.

In general, while trying to diversify we tend to create a large cap fund and/or a large cap index fund, a diversified and/or multi cap fund, one each from the mid and small cap fund.

Along with this an equity advantage fund would add flavor to the equity portfolio. While diversifying in an MF portfolio, the allocation towards sectorial or thematic funds possibly is the toughest of all the choices.

The complexity arises because it is not about adding one more fund which could be in-line with the risk profile of the investor and also non-correlating or less correlating to the existing portfolio.

But the problem is able to identify a theme or sector which would do well within the defined timelines and commit to the fund to realize the fruits of the investments.

This is contrary to all the understanding we have about equity markets about not to time the market or not to worry about timing the market. The choice or picking of a sectorial or thematic fund could well be akin to timing the market.

The nature of thematic or sectorial fund is to invest predominantly in the chosen stocks of the sector or them and making a concentrated approach.

This is once again refuting the purpose of diversification altogether or is it? It is clear that not all funds perform well in all kinds of markets and their cycles.

It's also an accepted and proven condition that markets follow economic cycles and only few sectors gain out of each such cycles.

If one enters into these funds as those particular sectors or themes and/or their stocks are performing well without considering the state of economic cycle i.e. at the beginning, in-between or peak stages then it would turn into trouble for the investors.

For instance, during the peak of 2006-07, market was flooded with infrastructure related or themed funds and investors got on these only to be stuck for years without returns and worst of all making huge un-replenishable losses.

Similar things happened during the dot-com bubble at the turn of this century when so many Information Technology (IT) sector stocks performed well and so such funds.

When investors got on to them within a year's time these funds have underperformed and also accumulated huge losses to the investors. Though, they turned out later it was almost a decade later which in a way hurt the investors. How many would've remained invested all through this?

Of course, in a well-diversified equity MF, the fund allocates majority of stocks into those sectors that would turn to do well or be part of the momentum stocks most of the times.

Though, the allocation could be only part of the entire fund, it still would help in having a decent exposure to those sectors.

And when these sectors or stocks begin to underperform the fund manager has the flexibility to move to other promising sectors and thus reduce the possible losses or underperformance by lowering or completely moving out of these stocks.

I know that sectorial or thematic funds are also an approved by the regulator, Securities Exchange Board of India (SEBI) and these are not without logic.

All I'm trying to raise is an alarm about the risks involved in these kinds of funds and it should be important for an investor to consider these factors well before investing in these funds.

These funds are probably helpful for investors who are investing in stocks directly or having a portfolio of stocks.

If their allocation is skewed towards a particular sector or if they're unable to allocate or identify good options in other sectors which they're either not very sure of or don't have great idea about then a sectorial or thematic fund would do well for the investor.

Another way to identify though not foolproof is to check the asset allocation of the best performing funds. The top allocation would help us perchance to identify the best performing sector.

Still, a 5-10% of the portfolio could be exposed to thematic or sectorial funds where one could ride the growth through a concentrated approach.

(The author is co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)