One of the biggest advantages of mutual funds is that they offer something for every type of investor. If you’re a conservative investor with an aversion to risk, you might want to opt for liquid or income funds for modest, but predictable returns.
If you’re open to a bit more equity exposure but still want some stability, hybrid options like balanced advantage funds and multi-asset allocation funds could be a good choice. For aggressive investors, there are several options like large-cap, small-cap, and multi-cap funds, which have their unique requirements and properties, and have varying levels of risk and return potential.
Within the equity category, different funds appeal to different risk appetites. Ultra-aggressive investors who can handle high risk often dedicate a part of their portfolio to options like thematic funds or sector funds.
While diversification is one of the core features of mutual funds, some investors feel it can also dilute potential returns despite lowering the risk associated with the investment. Sectoral and thematic funds reduce diversification by focusing on specific themes or sectors. This increases both the risk and the possibility of higher returns.
Let’s understand the differences between thematic funds vs sector funds by looking at how they work, what their benefits are, their taxation rules, and more.
What Are Thematic Funds?
A thematic fund, as the name implies, focuses on a specific theme, and not a particular sector. This is because thematic funds invest in an idea, a broader vision that encompasses several different sectors. Here’s an example to help you understand exactly the thematic funds’ meaning.
Imagine a fund that centres around the idea of infrastructure development. This is a broad field that not only covers physical infrastructure like railways and power plants but also digital infrastructure like telecommunication and the internet. Such a fund can include many sectors, like construction, producers and processors of raw materials like steel and cement, energy and power, telecoms, transportation, real estate, and others.
Yet another thematic funds example could be a commodities fund, which covers sectors like metals, agriculture, energy, and mining. An exports and growth fund can take advantage of sectors related to a service-based economy, spanning IT, pharma, textiles, and vehicles.
Similarly, a transportation and logistics themed fund can include transportation sectors like railways, shipping, ports, aviation, and road transport, while also including related sectors like construction, infrastructure, and manufacturing.
A popular type of thematic fund is the ESG fund. ESG stands for Environmental, Social, and Governance, so these funds invest in companies that follow environmentally sustainable and socially ethical business practices. They adhere to regulations set by authorities and take responsibility for any wrongdoings.
Thus companies that produce cigarettes or alcohol may be excluded from such a theme, as their products cause harm. Likewise, a company leaving a large carbon footprint and having a history of polluting water would also not be part of this theme.
So, what are thematic funds? They are a type of equity mutual funds that invest at least 80% of their assets in equity. They diversify across different sectors and industries, but their investments revolve around a core idea. The universe of stocks the managers pick from is larger compared to sectoral funds, which are tied down to one specific sector.
What Are Sector Funds?
With sectoral or sector funds, the investments don’t revolve around a central theme, rather, they are made in a defined, specific sector. For example, a fund investing in the pharma sector would include stocks of companies that manufacture and develop pharmaceutical products, such as drug companies, biotech firms, and companies involved in the research and development of medical treatments.
Of course, before a fund so specific is introduced, the outlook for the targeted sector is carefully assessed. Such funds invest only in sectors that show promise.
Another popular sector fund is a BFSI fund. A banking, financial services, and insurance sector fund, meaning a fund that invests in stocks of companies operating within the banking and financial services industry, is tied to the performance of that specific sector in the economy. Such a fund would not only be exposed to the normal risks a mutual fund faces but also risks specific to the banking sector.
So to answer the question of what sector funds are, these are a category of equity mutual funds where the fund manager invests at least 80% of the fund’s portfolio in equities. However, the companies that the manager selects belong to a single sector, like healthcare or technology.
Compared to thematic funds, the focus here is much tighter as assets are not diversified across sectors. This leads to an increase in risk and as a result, its returns heavily depend on the success of that particular sector. If the sector shows promise, the potential returns scale up handsomely as well.
Key Differences Between Thematic and Sector Funds
Let’s have a look at the differences between thematic funds vs sector funds:
| Factor | Thematic Funds | Sector Funds |
| Meaning | In thematic funds, the investments revolve around a core idea that spans multiple sectors, like an ESG fund. Here the fund aims to invest in companies that show strong environmental, social, and governance practices – This is the central requirement that companies must exhibit. Once companies with strong ESG practices are identified, their stocks are selected regardless of the specific sector they belong to. | The investments made in sector funds are confined to one specific sector, like the technology sector. The universe from which fund managers can choose is much smaller and more concentrated compared to thematic funds. The returns of sector funds are thus highly dependent on the performance of the selected sector. |
| Examples | Examples of thematic funds include transportation and logistics, export and services, manufacturing, green energy, ESG, and new IPOs funds. | Some sector fund examples are technology, BFSI, agricultural, natural resources, precious metals, pharma, auto, and FMCG funds. |
| Portfolio Diversification | Since these funds span multiple sectors, the diversification is higher. | Due to being tied down to a single sector, diversification of a sectoral fund is comparatively much lower. |
| Risk Involved | Thematic funds are very risky, though compared to sector funds the risk is lower due to diversification across sectors. | Sector funds are extremely risky and should only be considered by long-term investors with a high-risk tolerance. |
| Potential Returns | The returns can be potentially very high, however, may not be as high as sector funds due to a much broader vision. | The returns of these funds are tied to the fate of the sector they’re investing in. Should the sector perform well, the potential returns can be very attractive and beat those of a thematic fund due to a tighter focus. |
5 Benefits of Thematic Funds
1. Diversified across sectors
Thematic funds have a higher level of diversification compared to sectoral funds. Since they are anchored to a single idea, managers can explore different companies across sectors and market caps that fit that idea and create a portfolio capable of delivering high returns while mitigating sector-specific risks.
2. Can offer high returns
Since these funds try to capitalise on emerging trends in the market, they have the potential to deliver very attractive returns. For example, a fund related to green energy can take advantage of the growing demand for clean and renewable energy. In such a case, companies that produce solar panels, car manufacturers that make EVs, or energy companies that focus on wind power stand to benefit and so do their investors.
3. Active management
Fund managers are responsible for selecting companies that align with the core theme of the fund, so if investors are sold on an idea, they can trust the manager to make a portfolio that is well-positioned to capitalise on the growth potential of the theme.
4. Long-term investment
Since thematic funds are equity-oriented, they perform best in the long term, making them a good option for achieving goals like building a retirement fund and planning a child’s wedding.
5. Can be aligned with investor’s personal beliefs
Themes like ESG or green energy can promote responsible investing by aligning with an investor’s personal values. For example, if you are a high-risk appetite investor who wants to invest only in companies that are environmentally friendly or operate ethically, but also wants the benefit of professional management, convenience, and diversification, then thematic funds focused on ESG or green energy can be an ideal choice for you.
5 Benefits of Sector Funds
1. Offers potential for very high returns
If an investor can identify a sector poised for growth and enter before it begins to gather momentum, and then exit before it faces a downturn, they can earn massive returns due to the concentrated portfolio.
2. Allows sector-specific exposure
Sector funds invest in a sector that is likely to grow in the future. For investors who do not have exposure to a specific high-potential sector in their portfolio, these funds present a good entry point.
3. Diversification
It’s true that sector funds don’t offer as much diversification as other funds, but still, their portfolios are diversified across market caps and industries within the specific sector. For example, a technology fund can invest in a mix of large-cap technology giants, mid-cap growth companies, and smaller startups within the tech space.
4. Easier to track
Due to their focus on a single sector, it’s much easier to track the performance of a sectoral fund.
5. Professional management
Like any other mutual fund, sector funds offer the benefit of expert management. Investors who believe a particular sector may experience a boom in the near future but don’t have the time or experience to manage stock investments can take advantage of the fund manager’s expertise and knowledge of the sector.
Taxation Rules for Sector and Thematic Funds
Since both, sectoral and thematic funds are types of equity mutual funds, they follow the same rules that govern all equity-oriented funds. Tax is levied on dividends earned and capital gains made when selling the investment.
Dividend tax on a sectoral thematic fund
Ever since the Dividend Distribution Tax was abolished, investors have had to pay income tax on dividends earned. This income must be disclosed under the ‘Income From Other Sources’ head, where it is added to the investor’s income and taxed as per the tax slab. If you receive more than Rs. 5,000 as dividends in a financial year, your mutual fund house is required to deduct a TDS of 10%.
Capital gains tax
Capital gains tax is of two types – Short-term capital gains (STCG) tax, and long-term capital gains (LTCG) tax. If the investment is held for less than a year before selling, STCG tax is charged, whereas investments held for longer than a year are subject to LTCG tax. Here are the capital gains tax rules for thematic funds and sector funds:
- STCG Tax: A 20% tax plus additional cess is levied on profits made.
- LTCG Tax: Profits are charged a 12.5% tax without indexation benefits. Not only is the tax rate lower here, but investors are also exempt from paying any tax on the first Rs. 1.25 lakh capital gains earned in a financial year.
Conclusion
The key difference between sectoral and thematic funds is that the latter invests in companies that revolve around a similar idea or theme, like ESG or commodities, while the former has a much smaller universe from which it can select companies, as they are confined to a single sector, like natural resources, pharma, or technology.
Due to this, the diversification in thematic funds is higher, as investment is spread across multiple industries, and lower in sector funds. However, this lower diversification also makes the potential returns of sectoral funds higher.
Other than these, both types of funds are largely the same. They both must invest at least 80% in equities, are taxed the same, and are both very high-risk high-reward funds targeted at aggressive investors in it for the long term.
If you are interested in investing, it is imperative to understand your risk profile. You can consult with a financial planner who can help you select the right sectoral or thematic funds based on your investment horizon, risk tolerance, and financial goals, and create plans that mitigate the risks associated with these funds.
Their expertise can also help you take a holistic approach to your financial life through other services, such as tax optimisation, insurance, retirement planning, investment advisory, and portfolio management services, to guarantee that your financial future is secure and reflects your personal situation.
