Thematic Funds in India

1. Concentrated sectors in the portfolio result in limited diversification.
2. Falls into a high-risk category due to returns being linked to theme performance.
3. Best suited for aggressive investors; exposure should be capped at 10% of the portfolio.

Top Five Thematic Mutual Funds Sorted by Last Five-year Returns

Who Should Consider Investing in Thematic Funds

Thematic funds, being primarily driven by market volatility, are suitable for investors with an aggressive risk appetite. This necessitates investors to have a comprehensive understanding of their risk profile, encompassing both their capacity and willingness to undertake risks.

Investors who exhibit both the capacity and willingness to take risks can methodically choose funds that align with their risk profile and match the time horizon of their investment objectives.

Risks Associated with Thematic Funds

While the advantages of investing in thematic funds may appear appealing, it's crucial to comprehend the inherent risks, particularly their relatively concentrated risk approach.

Thematic funds share common risks with other mutual funds, including interest rate fluctuations, no guaranteed returns and the potential loss of principal amount due to market volatility, changes in government policy, and political developments. These risks are a direct consequence of equity market volatility and encompass the following:

1. Risk of Total Loss: Thematic and related securities may lead to a complete loss of principal investments.
2. Price Risk: Market conditions can cause daily price fluctuations.
3. Liquidity Risk: Settlement periods may unpredictably extend, and selling may be restricted due to the overall trading volume of specific stocks in the portfolio. This limitation can lead to potential losses and a decline in the scheme's value.
4. Event Risk: Any unexpected or detrimental event affecting an industry or company in which the mutual fund is invested can result in price risk.

How to Select the Appropriate Fund or Scheme

Choosing the right thematic fund scheme varies depending on individual preferences and circumstances, with the key factors revolving around the ability and willingness to take on risk. It's crucial to determine your own risk profile to identify a suitable fund or scheme. Additionally, factors such as financial goals and investment time horizon should be considered. Here are essential considerations when selecting a thematic fund tailored to your requirements:

1. Investment Strategy or Objective: Each fund has a defined investment strategy and objective, outlining its approach to investment. Understanding these approaches helps investors assess if they align with their preferences.
2. Alignment with Goals: Investment objectives may range from tax savings to long-term capital appreciation. Identifying your goals aids in finding funds that cater to these objectives.
3. Risk Versus Reward: Thematic funds entail higher risks for potentially higher rewards. By evaluating the risks associated with the mutual fund, investors can determine if they align with their risk profile and preferences.
4. Liquidity Requirements: Understanding the timeline for needing the investment corpus is crucial. Thematic funds are geared towards medium to long-term returns, typically requiring a minimum investment period of one year for results to materialise. If shorter liquidity needs exist, considering debt funds may be more suitable.

Taxation of Thematic Funds

As sectoral funds fall within the equity category, the capital gains generated from these funds are subject to taxation akin to other equity schemes. The taxation of gains from the sale of sectoral funds hinges on the duration of holding.

Short-term capital gains resulting from selling units within a year incur a fixed tax rate of 15%, regardless of an individual's income tax bracket. On the contrary, gains from sectoral funds held for over a year are classified as long-term capital gains and are taxed at 10% if they surpass Rs. 1 lakh. Gains of up to Rs. 1 lakh in any fiscal year remain tax-exempt.

Disadvantages of Thematic Funds

Thematic Funds also have their disadvantages. Some of the prominent ones are listed below:

1. The fund names may not indicate the real theme of the fund. If you are a newbie investor or have insufficient experience in mutual funds, you will not be able to understand the fund's portfolio unless you read the prospectus, investment objective, fund manager's background, etc.
2. You cannot have Thematic Funds as your core portfolio due to its high-risk nature. Ideally you should limit your investment in theme-based funds to 10-15% of your portfolio.
3. It is difficult to plan a strategy for Thematic Funds because there is no comparable fund or benchmark.
4. If the funds are international, you cannot predict the play of factors such as currency values on your investment.
5. Expense ratio for theme-based funds could range between 2.25%-2.5%, which is slightly more than what diversified equity mutual funds would cost you.

Difference between Thematic Funds and Sector Funds

Thematic Funds are often confused with Sector Funds, but there is a lot of difference between the two. Let us look at a few of the differences:

1. Sector Funds invest in 1 to 3 specific sectors - for example, the IT sector, the pharmaceutical sector, or the oil and natural gas sector - while Thematic Funds follow a theme in investment among different available stocks.
2. Theme-based funds are more diversified and have a larger scope than sector funds, but not as good as diversified equity mutual funds.
3. The risk level is high in both Sector Funds and Thematic Funds. Sector Funds, however, are riskier than Thematic Funds. The performance of Sector Funds depends on particular sectors, and if that sector is in a bad patch, the entire fund will be affected.
4. Theme-based funds, on the other hand, depend on the performance of different stocks in different sectors, which mitigates the risk considerably. It is still not an optimal situation, as the fund is not diversified enough to handle a rough patch in the limited stocks it has invested in.

If you plan to invest in theme-based funds, then ensure that you study carefully the portfolio of the funds and the market you are entering. You will need to choose a theme that has good track record and go for a fund manager who has experience in making wise investment choices.

Never make Thematic Funds your sole investment in mutual funds - diversify as much as possible to avoid losses.

GST rate of 18% applicable for all financial services effective July 1, 2017.