The Particular Risks of Thematic and Sector Funds

What you are actually buying

A diversified equity fund holds a wide spread of companies, and its outcome is roughly the market's outcome. A sector or thematic fund deliberately does not. It concentrates on one industry, or on one idea about how the future will differ from the present.

That concentration is the product. It is not a flaw in the design and it is not hidden. What is usually missing is a clear statement of what has to happen for the bet to pay, and that is three separate things rather than one.

The theme has to be right. The industry has to grow as expected, or the shift has to occur.

It has to not already be in the price. This is the step almost nobody accounts for, and it is the one that does most of the damage. Share prices already reflect what buyers and sellers collectively expect. A theme that everybody agrees is the future is priced as the future. For you to profit, reality has to exceed an expectation that is already optimistic — being right about the industry is not enough, because the price already assumed you were right.

You have to still be holding when it happens. Themes take years and do not move in straight lines. A fund can be right eventually and lose most of its holders on the way, because the intervening years were unpleasant enough that people left.

Miss any one of the three and the correct call still loses money.

The structural problem: when these funds appear

There is a pattern in how thematic funds reach investors, and it is not a conspiracy — it is what you would predict from how the industry works.

A fund gets launched when it can be sold, and it can be sold when the theme is already visible and performing well. That means new thematic funds cluster around the point where a theme has already done a great deal of its rising. The marketing material is accurate, the recent performance of the sector is genuinely excellent, and the entry price reflects both.

The consequence is uncomfortable and worth stating plainly. The fund's own record and the investor's experience of it can point in opposite directions, because most of the money arrives after most of the return has happened. A fund can report a fine long-run number while the majority of the people who held it did worse than that number, simply because of when they bought.

The general form of that trap — a good-looking record being least informative precisely when it looks most compelling — is examined on index data in why good returns do not make a portfolio safe.

Concentration cuts both ways, and not symmetrically

The case for a sector fund is that concentration amplifies the outcome. It does — in both directions, and the two are not mirror images.

A fall of a given size needs a larger rise to undo it, so a concentrated holding that halves needs to double to get back to level. Across a portfolio this asymmetry is dampened by holding many different things whose bad years do not coincide. Inside a sector fund it is not dampened at all, because the holdings share the thing that went wrong. That is the point of the fund.

There is a second, less obvious asymmetry. Whatever has risen most is now the largest part of what you own, so a thematic holding that has done well is a larger share of your portfolio than you chose it to be — precisely when it is most expensive. Unless you rebalance, the position sizes itself, and it sizes itself upward. That mechanism is set out in how rebalancing controls risk.

When one is defensible

None of this makes these funds illegitimate. There are two honest reasons to hold one.

The first is that you genuinely have a view that differs from the consensus, you can say what it is and what would prove you wrong, and you accept that you may be wrong. That is a real position, and the discipline is in the second half: a view you cannot state a falsifier for is not a view.

The second is that you want a small, deliberately sized exposure to something your broad-market holdings underweight, and you have decided the size in advance and will rebalance back to it. The size is the whole of the risk control here. A position small enough that being wrong changes nothing important is a position you can hold for the years the theme may need.

What is not defensible is buying because the recent returns are impressive. That reasoning selects for themes that have already run, which is exactly the population you would want to avoid.

The honest gap

This page tells you nothing about how Indian sector or thematic funds have actually performed, how their returns compare with diversified funds, or how much worse the typical holder did than the fund itself.

Every one of those is answerable and none of them is answerable here. It would need fund-level history for thematic and sector funds including the ones that were closed or merged after their theme fell out of favour — which is disproportionately what happens to them, so leaving them out would flatter the category badly. Measuring the gap between the fund's return and the holder's return needs flow data as well: when money actually arrived and left.

This site holds neither. So no figure appears above, and no comparison between categories is made. The arguments on this page are about structure — what has to be true for a concentrated bet to pay, and when such funds tend to be sold — and those hold without the data.

What to take away

A thematic fund asks you to be right about three things and rewards you only if all three land. The middle one, that the theme is not already priced in, is the one that is almost never discussed and the one most likely to be false at the moment you are being offered the fund.

If you want one, decide the size first, write down what would tell you the idea was wrong, and rebalance back to your chosen size when it runs. If you cannot do those three things, what you have is not a view about an industry. It is a purchase prompted by a chart.