Add spice to your portfolio

What can add a dash of spice to your mutual fund portfolio? A call on a fund that can soar well above your other funds, giving your returns a good leg up? Of course.

Sector and thematic equity funds fit this bill. IT funds, for example, returned in excess of 100% between 2020 and 2021!

But as tempting as returns may be, sector and thematic funds need to be used carefully in your portfolio. That’s because while their return potential is high, so is their risk. The tenets you may use for other equity funds don’t apply here either. Here’s more.

Know the difference

Sector and thematic funds form a category under equity funds. This is a very big umbrella that houses a great variety of funds. Therefore, the first step in using these funds is to understand what type they are, helps grasp the nature of risk you will be taking.

The riskiest type of fund within this category is pure sector funds, or funds that focus on a single sector. This could be financial services, IT, or pharmaceuticals, for example. Next come thematic funds, which are broader in scope than sector funds. Thematic funds are built to fit a particular theme such as consumption, manufacturing, infrastructure and so on.

Themes comprise multiple sectors. Consumption, for example, can range from FMCG to retailers to durables to paints and so on. The final type of fund is one that is akin to normal diversified equity funds.

These are funds where the theme is extremely general, allowing them to cover a wide variety of sectors. Examples here include ESG, opportunities, or business cycles.

Where’s the risk?

Sector and thematic funds are the highest risk in equity funds and choosing them is also equally tricky. This is where your approach to the funds will differ from normal equity funds. One, sectors and themes fall in and out of market favour. Getting into the sector at the right time is essential to allow you to gain those top-rung returns. It doesn’t stop there. You also need to exit the sector at the right time to pocket those gains.

Once a sector is no longer fancied, returns can collapse. In other equity funds, you don’t have to worry about sector movement and timing your investments as the fund itself will rotate allocations based on potential.

Two, a buy-and-hold long-term strategy does not work with sector or thematic funds. Once a theme moves out of market favour and returns decline, it is not necessary that markets pick it up again. Returns may come back in another market cycle or may not come in at all. Simply holding on to the fund for years on end will not help you recoup lost ground. This is unlike other equity funds where holding through a performance slump can pay off if the fund course-corrects.

Three, picking sector funds is tough. Folks tend to be attracted by high returns in a sector fund and then invest in it. On the contrary, that’s when the sector has already delivered much of its return and may have very little potential left! Entering sectors and themes is better done when returns are down, which allows you to ride the theme well.

And this calls for a firm understanding of markets, sectors, and trends. Choosing the wrong themes or sectors can weigh returns down instead of spicing them up.

How to use

For all these reasons, sector or themed funds need to be used carefully. So, first answer the question as to whether you need sector funds at all, no matter how attractive the returns may be!

While a theme or sector may do very well, in some market cycles, you can earn strong returns even through small-cap or mid-cap funds. If your portfolio is already well-diversified and you do not have market knowledge or advisers to identify the right sector at the right time, skip sector funds.

Also forgo these funds if your portfolio size is smaller. The usual mix of funds spanning market cap segments and investment styles provide sufficient diversification and return potential. More, wrong sector calls can hurt much more when your portfolio is smaller.

Otherwise, there are two ways to include thematic or sector funds. One is to simply improve portfolio diversification.

Here, look for broad thematic funds that pick stocks in a manner that your other funds may not — such as ESG, or opportunities, or MNC. Such an approach may suit moderate risk investors or those who don’t have in-depth market knowledge.

The other is to focus on specific sectors and narrower themes in order to cash in on outsized returns. This calls for a very hands-on approach, where you will need to churn the sector funds based on opportunities.

Since this involves very high risk, it is best that the rest of your portfolio is in more moderate risk funds. You also need to be a seasoned investor in order to adopt this approach.

In general, though, don’t go overboard on sector funds. The bulk of your portfolio should be towards diversified equity and debt funds. Measured allocations to sector funds will both help boost returns and keep a lid on risks.

When you pick funds, don’t chase only those with high recent 1-year returns, but consider the full list of funds. This is why knowing which theme can find market favour is important! Look at fund portfolios to know their approach to the sector and which help you understand if it’s well-placed to ride the theme.

A long track record is not an essential, but where you do have fund history, use it to know how the fund delivered during an upswing and how it manages over time.

(The writer is co-founder, PrimeInvestor.in)