How investors can use thematic funds to boost portfolio returns

Investors aiming to increase returns in their portfolios are turning to thematic funds due to the success seen with themes such as capital markets and defense recently. Thematic funds are mutual funds or ETFs that invest at least 80% of their assets in stocks linked to a specific long-term trend or theme, rather than a broad equity fund. Popular themes include defense, capital markets, consumption, tourism, energy, digital, public sector undertakings (PSUs), and manufacturing.

These funds can be either active or passive, with active funds employing fund managers to select stocks related to the theme, while passive funds track an index composed of companies in the theme. For instance, an infrastructure fund might invest in construction and cement companies like Larsen & Toubro, ABB, and Honeywell Automation.

Thematic funds carry higher concentration risk compared to diversified equity mutual funds, as they invest in a narrower range of stocks. However, they are generally less risky than sectoral funds like IT or pharma funds. If economic conditions favor the underlying companies, thematic funds can deliver high returns. However, adverse economic developments can lead to losses in the near term.

Many themes take time to play out, while the broader market may still rise, resulting in prolonged underperformance. Financial planners suggest that timing of entry and exit in thematic funds is crucial for generating high alpha. First-time investors should avoid thematic funds and start with diversified equity mutual funds. Once a core portfolio is established, investors can consider investing in one or two thematic funds to generate alpha and understand the associated risks.

Investors can allocate to thematic funds as part of their satellite portfolio, while maintaining a core portfolio of diversified equity mutual fund schemes.