The lure of thematic funds

Sep 18, 2023

I am constantly amazed at how investors flock to sector and thematic funds. But why does that surprise me? It is not a pattern that was birthed in the 21st century.

A riveting narrative, seeking to capitalize on changes taking place around us, and latch on to the next big thing, has lured investors for centuries. The Tulip Mania (1637), the Mississippi Bubble (1720) and the South Sea Bubble (1720) are well-documented examples in speculation mania and irrational exuberance. Abundance of intelligence, or the lack of it, is irrelevant. After all, according to this research, Issac Newton did not just “taste of the (South Sea) Bubble's madness, but drank deeply of it.”

Such funds rely on strong narratives because humans develop an emotional connect to them. I discussed that just last month in Don’t buy into a story.

The perceived plausibility of a well-crafted narrative is what exerts a powerful pull. Hence, the decision to invest in such a fund is often based on emotion and reaction rather than logic and reflection.

Melvyn Santarita, research analyst for Morningstar Investment Adviser India, informed me that the category of sector and thematic funds in India houses over 130 schemes.

In August 2023, this category witnessed inflows to the tune of Rs 4,805 crore. The reason for this spike could be attributed to five new fund launches. “The themes were varied - consumption, transportation and logistics, quant, innovation and manufacturing. And they cumulatively garnered Rs 2,556 crore in August 2023,” he says.

Investing in sectors and themes is the equivalent to a superfecta bet in horse/greyhound racing.

A superfecta bet is when you place a bet on the first four to finish the race, in the correct order. That’s a tall order, betting on which one will win the race, and which one will finish second, third and fourth.

When it comes to a sector fund, you must get four things right too:

  • Pick a winning theme.
  • Pick a fund that is well-placed to harness that theme.
  • Pick the time to enter.
  • Pick the time to exit.

Such funds can shoot out the lights one year and be a loser the next because they essentially lack the diversification to ride out trouble. Unlike a regular equity diversified fund, the fund manager does not have much latitude if the sector falls from favour. So volatility is a given.

For instance, energy funds put up a stellar performance in 2007 with a category return of 105%. Investors piled onto them. The Global Financial Crisis (GFC) hit the next year and the category average was -53%. While it bounced back in 2009, its returns in 2010, 2011 and 2013 were abysmal. In 2014, it made a comeback with a return of 47%.

Devina Mehra of First Global gave me some perspective when it comes to PSU stocks. “The PSU index crossed its 2008 high in 2023. That is a wait of 15 years! During this time, the index flirted with its high in 2010, 2014 and 2017, but never crossed it. In fact, there were multiple 50% drawdowns too.”

What are you considering?

If you simply gravitate towards the flavour of the year, you 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.

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.

Alex Bryan, director of product management for equity indexes at Morningstar, explains it.

“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.”

To ensure that emotion is not carrying you away, here’s what you need to do.

  • Most investors would be better off skipping thematic and sector funds. But if you find it appealing, then keep the position small and do your homework before investing.
  • If you play it well, sector funds will be able to deliver some stupendous returns on and off, giving your portfolio the muscle to outperform the market. Yet don’t lose sight of the fact that they can also log some dizzy falls. So do not let that disturb you or prevent you from sticking to your investment strategy.
  • One should never commit the grave error of investing in a thematic/sector fund simply because it has had a great run that year. You should be in a position to articulate your stance on why you believe that sector is likely to outperform, and what your criteria are for exiting it.
  • Always have an exit strategy in mind. What is your reason to offload? Do you have a return in mind? If the sector or theme rallies even a year after you invested and you made more than you thought you could, walk away. Don’t be afraid to leave potential gains on the table. Staying on in the hope that the sector will keep sizzling could backfire. You took a call and made money – don’t let greed mess it up. The market does not send out an invitation card informing you when to buy or sell. That is a call you have to make.
  • Research your fund. Not all thematic funds will effectively profit from the growth of their targeted trend. Yes, the portfolios are narrow, but all portfolios are not equal. Not in the stocks selected, the weightage to the top 5 stocks, or the number of stocks in the portfolio. Check the expense ratio too.
  • Finally, when you invest in a sector fund, you should be geared to take a hit. After all, you may get your call wrong. Or, it may take years to make a profit. That is why I reiterate that they should corner a very small portion of your portfolio and must never be a core holding.

Larissa Fernand is an investment specialist. Read her articles. Follow her on Twitter.

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