SIPs - a staggered approach to investing in sectoral/thematic funds to minimise risk

Mutual funds are the easiest way to diversify and earn inflation-beating risk-adjusted returns. As the markets peaked in recent weeks, investors have been perturbed about whether to invest in sectoral/thematic funds and if yes, how to manage the associated risks.

What are thematic and sectoral funds?

Thematic funds invest at least 80% of their total assets in stocks of a particular theme like public sector undertaking (PSU), infrastructure, MNC, business cycle, and manufacturing funds. Both risk and reward tend to be higher in thematic funds since they carry high-concentration risk. However, thematic funds are far more diversified than sectoral funds like IT or Pharma and have lower risk than them. During market peaks, thematic funds that invest in equities linked to a wider theme, not just a sector, tend to attract investors.

When investing in sectoral/thematic funds, investors may have extreme experiences.  If one invests at a time when the economy favours the underlying stocks, these funds can deliver high returns. On the other hand, any sudden adverse development in the economy can impact portfolio holdings, leading to a loss in the near term. For example, many investors, especially new ones, invested in IT and pharma funds in 2021-2022 because they rallied and offered great returns. They believed that since Covid is likely to continue, pharma funds may benefit in the years to come. However, this logic did not play out. 

Sometimes, thematic funds can even take longer to play out, while the broader market may continue to rally, thereby leading to underperformance for a longer time. The infrastructure sector, for instance, was a massive theme in 2007 but people who invested at that time are only beginning to generate returns now after over a decade of loss-making. So how can we minimise risks and maximise returns for these sectoral/thematic funds?

1. Make them part of your satellite portfolio:

One way retail investors can minimise risk is by allocating to a thematic fund as a satellite portfolio with the core portfolio invested in a mix of diversified equity mutual fund schemes. The investments in satellite portfolios are tactical allocations where a comparatively higher risk is taken to get higher returns. Usually, the total investment in the satellite portfolio is less than that in the core portfolio so that the greater risks do not adversely affect portfolio growth.  Investing in thematic/sectoral funds as a part of a satellite portfolio ensures that your goals are secured even if some risky investments do not give the desired results. 

2. Use SIP as a tool to minimise
risk: If you, as an investor, are convinced about a structural play for a sector or a theme, then opt for a systematic investment plan (SIP). Let’s consider the example of the banking sector.

As the economy grows, the banking sector will also grow. Within the banking sector, we have various sub-segments such as public sector banks (PSBs), private sector banks, non-banking finance companies (NBFCs), etc. In case one cannot take a call on which of these will play, then one can opt for SIPs in a thematic fund which will have exposure to all these sub-segments.

To conclude, investors can diversify investments across core and satellite portfolios to weather market volatility, based on their investment goals, risk appetites, time horizons, etc. The preferred way to enter a sectoral/thematic fund would be through SIPs rather than through a lumpsum investment.

(The writer is Head Investment Strategy, ICICI Prudential AMC)