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K.Venkatasubramanian

If you thought choosing appropriate mutual funds for investment was an easy task, think again. Diversified funds, sector funds, theme funds, tax saving funds… the list just keeps growing.

What is the investment logic of diversified, sector and theme funds and how can such funds fit into portfolios of young investors like you? Read on to find out.

As the name suggests, these funds invest in a wide basket of stocks, picked from several industries. Diversified funds are particularly suitable when the market rally is across the board. That is, when many sectors and stocks are expected to do well.

This diversified approach creates many advantages. First, it reduces the risk from concentrated holdings in select stocks or sectors. Performance is not dependent on the returns of a small set of stocks or a particular sector. If some sectors/stocks are not doing well in the portfolio, the other ones may be expected to outperform and deliver better returns and, therefore, compensate investors.

On the other hand, if sentiment in the market is bearish, many sectors could simultaneously go crashing down! Usually, however, some sectors are more adversely hit than others. For instance, the prospect of a US recession creates jitters in the Indian markets. But stocks of export-oriented companies take a greater hit than domestic-focused companies. The extent of decline suffered by a diversified fund, which invests across sectors, is likely to be less or, in other words, the blow may be softened.

Second, diversified funds can invest across market capitalisation — small, mid and large — and take advantage of any rally in these stocks. Of course, there are exclusive large, small and mid-cap funds as well. However, a fund that has the flexibility to invest in stocks of varied market capitalisation may be in a better position to capitalise on prevailing trends in the market and could deliver superior returns over the long term.

Third, even as they stick to the principle of diversification, diversified funds can step up exposures to themes that are in market fancy at any given time and gain from the momentum in those sectors. Therefore, investing in diversified funds does not mean that you will miss out on prevailing ideas.

Fourth, a diversified fund reduces the importance of timing the market. This is because there is a long window of opportunity for different sectors to outperform and deliver superior returns. A diversified fund can also quickly switch its preference between sectors and themes and continue to outperform the market over a long period.

Because of these features, diversified funds are suitable for long-term investors.

A theme fund invests in sectors surrounding a theme. For example, the technology theme may be taken to include IT services, telecom, media and entertainment sectors. But the central theme remains the same. Similarly, infrastructure can be taken to include sectors such as construction, capital goods, power and power equipment, and so on.

The advantage that these types of funds have is that when there is a sustained momentum in certain theme(s), the return upside can be substantial. In such phases of the market run, the returns from such themes are generally much better than the market. This has been the case with the infrastructure theme over the last three years.

But the disadvantage is that when the theme is out of favour, the slide in the fund’s NAV will be substantial and worse still, diversification to reduce risk is not possible as the fund has a specific mandate to invest in a theme only.

A sector fund, on the other hand, invests only in a single sector. For example, a banking fund will invest only in banking stocks or a power sector fund will invest in power transmission/distribution and power equipment stocks and so on. That is while a fund manager has the option to exit a stock in the sector, he cannot exit the sector itself!

Suffice it is to say that sector funds may be deemed much more volatile and risky than theme funds.

Diversified versus theme — In which type of fund should I put my money?

The phrase that guides all equity market relationships — ‘depends on your risk appetite’— is applicable here as well!

This means that your choices are dependent on your age, income levels, liquidity requirements and investment horizon. But if certain factors are kept in mind, a strategy can definitely be evolved.

A diversified fund with a good track record may be able to deliver steady returns across market upswings and reduce the negative impact during market downslides. So, these types of funds should form the core of your portfolio. That is, a good percentage of money should be parked here.

If the investment horizon is, say, five-ten years, then a strong portfolio comprising four to five diversified funds may be considered. A lump-sum investment is not a prerequisite. A SIP (systematic investment plan) may be considered by way of small monthly investments. This further minimises the impact of poor market timing and helps cost averaging during market downs.

A theme/sector fund investment may also be considered, but only if you are bullish on the sector(s) or theme(s). But considering the risks associated, these should form a smaller part of your portfolio.

Another aspect to be noted here is that in theme funds, the window of opportunity may be shorter. The market may fancy a theme for some time but it could suddenly go out of favour. This means two things. One, timing of the entry and exit is important. So you must be fairly knowledgeable about the sector or theme and be in a position to actively manage your investments in such theme funds. Second, investing a lump-sum may be a better option as it will maximise your return. Here again, invest in lump-sum only the surplus that you are unlikely to need for the medium term.

A mix of diversified and theme funds in line with your risk appetite will go a long way in increasing your returns. Figure out your goals and invest accordingly.

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