2.1.17 Sector & Thematic Investing

Betting on a slice, not the whole market

A diversified equity fund spreads risk across many industries. A sector fund deliberately gives that diversification up in exchange for concentrated exposure to a single industry's fortunes. A thematic fund does something similar around an idea, such as clean energy or digital transformation, that may span several industries but shares a common story.

The dividing line is concentration. A diversified fund holds dozens of companies across many sectors, so a problem in any one is cushioned by the rest. A sector or thematic fund deliberately removes that cushion, which is what gives it both its higher upside when the theme works and its deeper, more prolonged downside when it does not.

Why the extra risk is real

When a chosen sector or theme is in favour, concentrated exposure can significantly outperform the broader market. When it falls out of favour, which every sector and theme eventually does for some period, the same concentration works just as strongly in reverse. Sector and thematic funds have historically shown much wider swings in relative performance than diversified funds, in both directions.

The timing problem is the real trap. By the time a sector's strength is visible and widely discussed, much of the gain has already happened. Investors who bought pharma funds in mid-2020 caught the pandemic-driven surge; those who bought in late 2021, after the theme was well known, endured years of flat-to-negative returns as valuations normalised. AMFI flow data consistently shows the sectors attracting the largest inflows in a given year often underperforming the broad market over the following three to five years, a direct consequence of buying high within a cycle.

A sensible role for these funds

Most planners suggest keeping sector and thematic exposure to a modest satellite portion of a portfolio, layered on top of a diversified core, rather than as the main engine of long-term wealth building. That way a single sector's bad multi-year stretch cannot derail the whole plan.

A common guideline is to cap sector and thematic exposure at 10-15% of the total equity allocation, with the core held in diversified large-cap or flexi-cap funds. The Indian record is full of cautionary examples: IT funds soared in the late 1990s then languished through much of the 2000s; infrastructure funds shone in 2005-07 then destroyed value for a decade. The challenge is never spotting a promising sector but timing entry and exit, which even professionals struggle to do consistently.