Thematic funds vs. sector funds: Key differences and which is more suitable for you?

Investing in mutual funds is not a one-size-fits-all approach; it requires careful consideration of your financial goals, risk tolerance, and market outlook. Thematic mutual funds and sector mutual funds are designed for investors looking to capitalise on specific economic trends or industries. However, understanding their differences is crucial for making an informed investment decision. For instance, while sectoral mutual funds focus narrowly on a single industry like IT or healthcare, thematic investment funds cast a wider net, targeting multiple sectors linked by a broader theme such as sustainability or digital innovation. This distinction can significantly impact your portfolio's risk and return dynamics.

Table of contents

• What are sectoral funds?
• What are thematic funds?
• Key difference between thematic and sector funds
• Taxation rules for sectoral and thematic funds
• Thematic funds vs. sector funds: Advantages and disadvantages
• Thematic funds vs. sector funds: Which is more suitable for you?

What are sectoral funds?

Sector mutual funds, also known as sectoral mutual funds, are equity funds that invest exclusively in a specific sector or industry. These funds aim to capitalise on the growth potential of a particular sector by investing in companies operating within it.

For example:

• A healthcare sector fund may invest in pharmaceutical companies, hospitals, and medical device manufacturers, among others.
• An IT sector fund may focus on software companies, IT services providers, and tech hardware manufacturers, among others.

Key features of sectoral funds:

• Concentration: Investments are limited to one sector.
• High risk-high reward: Performance is closely tied to the success or failure of the chosen sector.
• Market timing: Success often depends on accurately predicting when a sector will outperform.
• Investment horizon: Typically suited for medium-term investments (3–5 years).

Sectoral funds can be suitable for investors with deep knowledge of a particular industry and a high-risk appetite.

What are thematic funds?

Thematic mutual funds, or thematic investment funds, are equity funds that invest based on overarching themes or trends expected to drive economic growth. Unlike sectoral funds, thematic funds span multiple sectors connected by a unifying idea.

For example:

• An ESG fund may invest in a broad range of companies, from renewable energy to electric vehicle manufacturers and green technology firms.
• A digital innovation thematic fund could include tech companies, e-commerce platforms, and fintech firms.

Key features of thematic funds:

• Diversification: Investments span multiple sectors related to the theme.
• Trend-Based: Performance depends on the success of the chosen theme.
• Flexibility: Fund managers can adapt to evolving market trends within the theme.
• Investment Horizon: Suited for long-term investments (5–7 years).

Thematic funds are suitable for investors who believe in macroeconomic trends and have a higher risk tolerance.

Key difference between thematic and sector funds

Parameter	Thematic funds	Sectoral funds
Investment focus	Broader themes spanning multiple sectors	Specific industries or sectors
Diversification	Relatively diversified	Limited diversification
Risk profile	Moderate to high (theme-specific risks)	High (sector-specific risks)
Return potential	Depends on the theme's success	Depends on sector performance
Volatility	Lower than sector funds due to diversification	Higher due to concentrated exposure
Investment horizon	Long-term (5–7 years)	Medium-term (3–5 years)
Suitability	Investors aligned with macroeconomic trends	Investors confident in one sector's growth

Taxation rules for sectoral and thematic funds

1. Short-term capital gains (STCG)

   • Before July 23, 2024: Gains from units held for less than one year were taxed at 15%.
   • After July 23, 2024: The tax rate for short-term gains has increased to 20%, applicable to all equity mutual funds, including both sectoral mutual funds and thematic investment funds.

2. Long-term capital gains (LTCG)

   • Before July 23, 2024: Gains from units held for more than one year were taxed at 10% if they exceeded Rs. 1 lakh in a financial year.
   • After July 23, 2024: The tax rate for long-term gains has increased to 12.5%, applicable to gains exceeding Rs. 1.25 lakh in a financial year. The exemption limit for LTCG has also been raised from Rs. 1 lakh to Rs. 1.25 lakh.

Strategic considerations for investors

• Investors in both thematic investment funds and sectoral mutual funds should focus on longer holding periods to mitigate the impact of higher STCG rates.
• For those with substantial investments, planning around the Rs. 1.25 lakh LTCG exemption can help optimise tax efficiency.
• Given the higher tax rates, diversification into other asset classes or fund categories may be worth considering, depending on individual financial goals and risk tolerance.

Thematic funds vs. sector funds: Advantages and disadvantages

Advantages of thematic funds

• Broader diversification mitigates concentration risk.
• Flexibility to adapt to changing market conditions.
• Potentially higher returns if the theme gains momentum.

Disadvantages of thematic funds

• Success heavily depends on the theme's relevance over time.
• Higher volatility compared to diversified funds.

Advantages of sectoral funds

• Opportunity for substantial returns if the chosen sector outperforms.
• Easier to track performance due to focused investments.

Disadvantages of sectoral funds

• High concentration risk: poor performance in the sector can significantly impact returns.
• Requires precise timing for entry and exit.

Thematic funds vs. sector funds: Which is more suitable for you?

Choosing between thematic and sectoral mutual funds depends on your investment goals, risk tolerance, and market knowledge:

1. Choose thematic funds if
   • You believe in long-term macroeconomic trends like sustainability or digital transformation.
   • You prefer diversification across multiple sectors within a theme.
   • You have a higher risk tolerance and a long-term investment horizon.
2. Choose sectoral funds if
   • You have expertise in a specific industry and confidence in its growth potential.
   • You are willing to take higher risks for potentially higher rewards.
   • You aim for medium-term tactical plays rather than long-term investments.

Conclusion

Investing in specialised mutual funds like thematic or sectoral funds can be rewarding but requires careful consideration. While both fund types offer opportunities for high returns, they come with unique risks tied to their focus areas. For instance, thematic investment funds provide broader exposure across multiple sectors linked by a trend but require faith in long-term macroeconomic shifts. On the other hand, sectoral mutual funds offer concentrated exposure with potentially higher short-term returns but demand precise market timing and deep industry knowledge.

Ultimately, your choice between Thematic Mutual Funds vs. Sector Mutual Funds should align with your financial goals and risk appetite. Diversification remains key—consider balancing these specialised investments with core diversified equity funds for optimal portfolio performance.

FAQs:

What is the difference between thematic and sector funds?

Thematic funds invest across multiple sectors tied to a broader theme like clean energy or digital innovation, while sectoral funds focus narrowly on a single sector such as IT or healthcare.

Is it good to invest in thematic funds?

Yes, thematic funds can be suitable if the chosen theme performs well over time. However, they come with higher risks due to their reliance on specific trends.

What is the difference between sector investing and thematic investing?

Sector investing targets one specific sector(e.g., pharmaceuticals), while thematic investing focuses on overarching trends influencing multiple sectors(e.g., renewable energy).

What are the disadvantages of sectoral funds?

Sectoral funds carry high concentration risks; poor performance in the chosen industry can lead to significant setbacks. They also require precise market timing.

What is the tax treatment for short-term gains in these funds?

Short-term capital gains from both thematic and sectoral mutual funds are taxed at 20%, regardless of income tax brackets.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.