Investing in mutual funds on the basis of past returns is not a good idea

How to pick sectoral and thematic funds: Key things you need to keep in mind while investing in mutual funds This is especially true in case of sectoral and thematic funds. Sectors and themes tend to be cyclical in nature, and the performance depends on a host of factors, including news developments, economic conditions, global trends, government policies and market sentiments. For instance, the pharma sector was the top performer after the Covid outbreak in 2020, but it was the worst performer in 2021 and gave negative returns the next year Investors have poured nearly Rs.55,000 crore in these funds in the past six months. Find out if these schemes suit you

Mutual funds have witnessed a record inflow of more than Rs.1.4 lakh crore in the past six months, with nearly 40% of this amount going into thematic and sectoral funds. Sectoral and thematic funds are riskier because they are less diversified and take a concentrated exposure to a sector or theme. Here are a few things investors must keep in mind to avoid disappointment later.

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Our cover story explains why investing on the basis of past returns is not a good idea. This is especially true in case of sectoral and thematic funds. Sectors and themes tend to be cyclical in nature, and the performance depends on a host of factors, including news developments, economic conditions, global trends, government policies and market sentiments. For instance, the pharma sector was the top performer after the Covid outbreak in 2020, but it was the worst performer in 2021 and gave negative returns the next year. “That’s how cyclicality plays out,” says Chirag Muni, Executive Director, Anand Rathi Wealth.

To navigate these cycles, investors must keep their ears close to the ground. For instance, government policies can change a sector’s fortunes. After the government announced in 2020 its plans to spend Rs.100 lakh crore on infrastructure over the next five years, infra stocks took off. The infrastructure category gave more than 50% return in 2021. It lost some steam in 2022, but powered ahead in the following years.

Concentrated exposure,high volatility
At the same time, sectoral and thematic funds are more volatile because they have a concentrated exposure to one sector or theme, unlike a diversified fund that spreads the risk thin across several sectors. Since the universe is narrow and there are only a few stocks to invest in, the top 4-5 stocks in a sector or thematic fund account for a significant portion of the portfolio. A downturn in one or two holdings can impact the fund adversely. For example, the HDFC Defence Fund has doubled investors’ money in just nine months. However, two stocks—Hindustan Aeronautics and Bharat Electronics—account for more than 50% of its portfolio, which makes the fund very risky. If any of these two stocks slips, the fund will follow suit.

Given the high risk they carry, sectoral and thematic funds are not for everyone. Experts typically recommend these funds only to investors who can stay ahead of the curve and have good knowledge of recent developments, trends and policy changes.

“We don’t recommend sectoral and thematic funds unless the investors have a special requirement for a sectoral or thematic inclusion in their portfolio,” says Santosh Joseph, Founder, Germinate Investor Services. These funds are suitable for savvy investors who understand sector dynamics and are willing to take extra risk to earn higher returns.

Not for the long term
The cyclicality of sectoral and thematic funds also means that they are not meant to be kept in the portfolio forever. Just like savvy investors know when to get in, they also know when to exit.

“The timing of the exit is extremely crucial. If you get it wrong, you’ll be in it for a really long time without making any money,” says Joseph. “In 2008, alwayswhen the power and infrastructure sectors were doing very well, there were several NFOs in the infrastructure category. The people who invested in these funds, but failed to exit at the right time, suffered losses when the tide turned against these sectors. It took almost 8-10 years for these funds to recover,” adds Vivek Banka, Co-founder, Goalteller.

Though these funds have the potential to provide high returns, sectoral funds should not form the core of your investment portfolio. According to financial planners, one should not allocate more than 10-15% of the portfolio in sectoral or thematic funds. The core of the portfolio should be an index fund and diversified schemes.

Also, when a sectoral or thematic fund gives good returns, book partial profits. “Rebalance your portfolio by taking out profits from thematic funds once it exceeds the allocated percentage,” says Banka.

How different sectors have performed in the past 10 years
Sectors are cyclical in nature, which means new winners are thrown up every year.
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This story originally appeared on: India Times - Author:Faqs of Insurances