What to check before investing in sectoral and thematic funds: Key risks and ratios explained

Sectoral and thematic funds are one such mutual fund category that allows you to invest in a particular sector or investment theme. Unlike diversified equity funds, these schemes have a concentrated portfolio, making it important for investors to thoroughly analyze risk factors before investing.

So, let’s explore the risks and metrics you need to consider before investing in sectoral and thematic funds.

What are sectoral and thematic funds?

As per SEBI guidelines, sectoral/ thematic funds are required to invest at least 80% of the accumulated funds into the stocks of the specific sector and theme. Both sectoral and thematic funds are types of equity mutual funds, but they follow a different approach.

Sectoral funds invest in a specific sector, such as banking, technology, pharmaceuticals, FMCG, etc. Since these funds invest only in one sector, they offer limited diversification benefits.

The performance of these funds largely depends on the growth cycle of that particular sector. Some of the examples of sectoral funds are SBI Banking & Financial Services Fund, ICICI Prudential Technology Fund, and UTI Healthcare Fund.

Thematic funds, on the other hand, invest in stocks linked to a specific theme rather than a single sector. These themes may include public sector undertakings (PSUs), MNCs, manufacturing, etc.

As thematic funds spread investments across multiple sectors linked to a common theme, they are relatively more diversified and usually carry lower risk compared to sectoral funds. Some of the examples of thematic funds are Tata India Consumer Fund, DSP Natural Resources and New Energy Fund, and ICICI Prudential MNC Fund.

What are the key risks associated with sectoral and thematic funds?

Concentration Risk

Sectoral and thematic funds invest in a limited set of companies linked to a particular sector or theme. Since investments are concentrated in a single sector, poor performance in that space can impact the entire fund.

For example, if the banking sector is going through a downfall, then such funds face more pressure than diversified equity funds as they are concentrated in one sector.

Policy Shocks

Government regulations, taxation, and policy reforms can directly affect particular sectors and themes.

If the government focuses more on a renewable energy push, then funds dependent on this theme will directly benefit due to policy tailwinds. However, a reduction in policy support or stricter regulations can negatively impact the sector and the fund’s returns.

Valuation Risk

As valuation remains a key concern for any sector, the sectoral and thematic funds also face the risk. If the fund manager has bought the underlying stocks at expensive valuations, then it can lead to losses if earnings don’t justify that.

For example, defence stocks often rally at the time of geopolitical tension. However, if company earnings fail to justify the sharp rise in valuations, these stocks may witness a correction, which can eventually impact the NAV of defence funds.

Entry and Exit Risk

Many investors enter sectoral and thematic funds like a stock by buying at high prices and then selling during market corrections.

Reacting to short-term corrections in a particular sector can result in losses, instead of helping investors achieve their long-term wealth creation goals.

Key metrics to analyze while investing in sectoral and thematic funds

As the concentration, policy, and valuation risks are part of the sectoral and thematic funds, there are a few metrics you can consider to analyze them.

Portfolio Allocation

One of the most important factors to consider while investing in sectoral and thematic funds is the portfolio allocation. For this, you need to check the top 10 stock holdings of a fund to analyze where the fund is majorly concentrated.

For example, SBI Banking & Financial Services Fund's top 2 stock holdings are ICICI Bank and Kotak Mahindra Bank, while Nippon India Banking & Financial Services Fund holds larger allocations in HDFC Bank and ICICI Bank.

It is important to compare apples to apples, meaning one sectoral fund should be compared with another sectoral fund for an accurate analysis.

Beta

Beta measures how volatile the fund is as compared to its benchmark index. If a fund has a beta of 1, it means that its performance moves in line with the benchmark index.

For example, SBI Banking & Financial Services Fund has a beta of 0.88, while Nippon India Banking & Financial Services Fund has a beta of 0.95. This indicates that the SBI Fund is relatively less volatile compared to the benchmark and may carry slightly lower market risk than the Nippon India Fund.

Maximum Drawdown

Maximum Drawdown (MDD) is the largest observed percentage drop in a mutual fund's value from its highest point to its lowest point before it recovers to a new peak. In sectoral and thematic funds, MDD helps investors understand how much the fund can fall during weak market cycles, policy changes, or sector-level downturns.

For example, SBI Banking & Financial Services Fund has a negative MDD of 14.42%, while Nippon India Banking & Financial Services Fund has a negative MDD of 15.14%. This shows that the SBI Fund had a lower decline during market corrections.

PE Ratio

The risk of sectoral and thematic funds mainly depends on sector or theme performance, earnings cycles, government policies, and broader market sentiment.

This can be analysed using the PE (price-to-earnings) ratio. A fund with a lower PE ratio than the category average is generally considered better from a valuation perspective.

For example, SBI Banking & Financial Services Fund has a PE ratio of 14.53 and it is higher than the category average of 13.55, indicating that the fund is slightly expensive.

Disclaimer: This is purely for educational/ informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.