Thematic Mutual Fund: Meaning, Features and Disadvantages

The world of investing is always innovating. Over time, many strategies, models, systems, etc., have entered the investment world. However, it is important to note that many of these had their genesis in the developed markets.

These days, fund investors frequently come across 'ESG' funds launched by many fund houses. A related concept is socially responsible investing (SRI). So, what exactly are these two? Let’s understand them. 

ESG funds seek to invest in businesses that score high on environmental, social and governance (ESG) standards. Over time, ESG investing has become quite a rage in the developed markets, as seen from the surge in funds and indices constituting socially responsible, impactful, sustainable, etc.

One might want to be selfless with one's investments as an individual investor. For such kinds of investors, ESG investing could be a way to give back to society and be more proactive towards conserving the environment. Investor support for ESG-grade companies might motivate businesses to change their attitudes instead of just chasing profitability at any cost. 

However, note that not all 'green' investments are green. One may consider using natural gas as more environmentally friendly than coal. However, when one considers the process of extracting natural gas and its long-term ill effects on health and the ecosystem, the so-called 'green' investment starts to look black.

The world's preparedness towards handling a pandemic-like situation was found wanting when an actual pandemic hit us in 2020. This has led to a strong case for better handling of matters relating to climate change as its effects would be more long-lasting and, in certain cases, irreversible, with no ready solution. Thus, ESG factors are being considered more seriously from a risk mitigation perspective.

However, socially responsible investing takes one step further than ESG by removing or adding investments based solely on a specific ethical consideration. For example, an investor might avoid exchange-traded funds (ETF) or a mutual fund with firearm manufacturer stocks. Alternatively, an investor might allocate a fixed proportion of their portfolio to stocks of companies that donate a higher proportion of their profits to charitable causes.

Socially responsible investors might also avoid companies associated with:

• Alcohol, tobacco, and other addictive substances
• Weapons production
• Gambling
• Environmental damage
• Human rights and labour violations

Difference Between ESG and SRI 

A lack of standardisation in terminology has led to confusion over how ESG investing and sustainable investing differ. Let’s discuss them one by one. 

Through ESG investing, market participants consider how environmental, social, and governance (ESG) opportunities and risk can impact a company's performance. Investors who use ESG in their decision-making can invest sustainably while maintaining the same financial returns as they would with an otherwise standard investment process.

Sustainable investing, also known as impact investing or socially responsible investing (SRI), puts a premium on positive social change by considering financial returns as well as moral values in investment decisions. This lays importance on financial returns as a secondary consideration after the moral values of investors have been accounted for in their decision-making.

As companies and investors continue prioritising decision-making that benefits stakeholders alongside stockholders, ESG investing has emerged as a competition to sustainable investing. 

ESG includes various environmental, social and governance considerations on which companies are measured. It also reflects the increasing interest of investors more concerned about companies adopting practices that will mitigate risk and ensure their long-term sustainability. As a result, ESG issues are increasingly shaping how companies carry out their business worldwide.

ESG investing offers a more practical approach to addressing financial material issues through a broader information set. Investments in physical and human capital, climate risks and environmental challenges, good governance characteristics, etc., can greatly improve a company's performance through an ESG-minded investment strategy.

Since the term was first popularised in 2005, investors have increasingly seen value in using ESG criteria to guide investment decisions. This idea of ESG investing is an evolution of the trend toward socially responsible investing. Still, the ESG framework provides a broader solution for looking at social impact beyond eliminating companies associated with negative outcomes.

In contrast, socially responsible investing allows investors to conduct positive and negative screens to invest in companies that engage in sustainable practices such as consumer protection, environmental stewardship, human rights, and racial and gender diversity. Socially responsible investors avoid investing in companies or organisations whose businesses run counter to their non-financial values and ethical principles or those they perceive to affect society negatively, including businesses across the alcohol, fast food, tobacco, gambling, weapons, fossil fuel, or defence industries.

As ESG investing has emerged as an alternative to socially responsible investing, investors increasingly seek forward-looking metrics to assess portfolio risk beyond traditional measures. For instance, S&P Global Ratings ESG Risk Atlas provides a comprehensive outlook of relative ESG risks facing various geographies and sectors. The ESG Evaluation assigns weight to potential ESG risks to determine a company’s capacity to operate successfully, along with a preparedness assessment of a company to anticipate and adapt to various long-term disruptions, which determines the company's final ESG score. 

Because ESG investing considers an organisation's environmental, social, and governance opportunities and risks that could significantly impact its performance, these factors can be used to comprehensively expand upon and enhance the traditional measurements of a company’s performance in informing investors' decision-making.

While socially responsible and ESG investing are both ways sustainable practices can be incorporated into decision-making and investment strategy, ESG investing has proven to be an exemplary and contemporary choice. Investors who take the ESG route are well equipped with metrics that quantify financial opportunity and risk, while socially responsible investors engage in decision-making primarily based on principle. To facilitate long-term, sustainable growth, it is imperative to analyse a company's ESG performance and examine how market activity influences our world.

Thematic Funds 

Thematic Funds are the kind of mutual funds invested in companies' stocks that adhere to a particular theme. This theme could be anything - international stocks, multi-sector stocks, commodity stocks, rural India, infrastructure stocks, green energy, etc. Therefore, under thematic funds, the fund manager identifies a central theme and builds a portfolio around it. Investors willing to invest in the theme pool their investments into a corpus. The fund manager then allocates the corpus to the equity-oriented instruments of companies that match the overall theme of the fund. Thus, The portfolio is diversified across various stocks, yet the investment theme remains the same. When the value of the portfolio's underlying assets increases, you can earn a profit. If, however, the value falls, you endure a loss.

However, you should not confuse them with sectoral funds. Thematic funds invest in stocks of companies that are married to a particular idea. Take ESG funds, as discussed above, for example. Belonging to the thematic family, these funds are exclusively invested in companies that rank high on environmental, social, and corporate governance factors. Since thematic funds have a particular ideology, they have a handful of stocks to invest in.

Features of Thematic Funds

The following are the features of investing in theme-based funds:

• Thematic Funds are more focused and semi-diversified. Therefore, if a particular theme plays out in the investor's favour, returns can be exemplary. 
• Theme-based funds are high-risk and high-return but can be unusual. The performance of the funds depends on the limited number of companies or sectors being invested in.
• If one of the companies has a long winning streak, you will benefit highly, but when one of the two stocks starts plunging, you will incur losses. Thus, Thematic Funds are better for short- and medium-term investments than long-term ones.
• Theme-based funds are best suited to mature investors and those who follow market trends and can make analytical decisions.

Disadvantages of Thematic Funds

Thematic Funds also have their disadvantages. Some of the prominent ones are listed below:

• The fund names may not indicate the real theme of the fund. Suppose you are a newbie investor or have insufficient experience in mutual funds. In that case, you cannot understand the fund's portfolio unless you read the prospectus, investment objective, fund manager's background, etc.
• Due to its high-risk nature, you should not have Thematic Funds as your core portfolio. Ideally, you should limit your investment in theme-based funds to 10-15% of your portfolio.
• Planning a strategy for Thematic Funds is difficult because there is no comparable fund or benchmark.
• If the funds are international, you cannot predict the play of factors such as currency values on your investment.
• The expense ratio for theme-based funds could range between 2.25%-2.5%, slightly more than what diversified equity mutual funds would cost you.

Suitability for Thematic Funds

Thematic funds can be a good addition to your portfolio. However, you should assess their suitability before you invest in them. Thematic funds are suitable for the following types of investors.

• Those who have a healthy risk appetite

Since thematic mutual funds are mostly equity-oriented schemes, you must have a matching risk appetite to bear market volatility risks. The risks might be limitedly diversified due to the portfolio allocation, but they would not be entirely eliminated. So, if you are risk-averse, be mindful of the risks.

• Those who have a long-term investment horizon

Equity mutual funds can offer good returns if you invest with a medium to long-term horizon. So, if you have such an investment horizon, you can invest in thematic schemes and expect good returns. Short-term investors, however, may face high volatility if the underlying theme does not meet their expectations.

• Those who have the market knowledge to identify potential themes

Thematic investing works well only when you can tap into the right theme. To know which theme has good future potential, you must be well conversant with the market factors. Thus, investors with a basic understanding of the financial markets and identifying potential themes are more suited to pick thematic funds for their portfolios.

Things To Remember When Investing in Thematic Funds

It is important to keep the following things in mind when investing in thematic funds:

• Refrain from picking funds based solely on their historic performance alone. Historical returns are not an accurate indicator of future returns. Pick a scheme based on the theme you believe has growth potential and would give good returns.
• Compare between different thematic schemes and then choose a scheme that has offered consistent returns in the past. Consistency in returns shows the efficiency of the fund manager and is a good parameter to assess when investing in thematic funds.
• Check the expense ratio of different funds. If two funds have similar characteristics, pick a scheme that has the lowest ratio for maximum gains in the long term. 

How To Invest in Mutual Funds on Angel One?

1. Open the Angel One app. On the Home page, go to ‘Mutual Funds’.
2. Choose the Mutual Fund that you want to invest in from the various lists provided on the Mutual Fund portal.
3. Choose whether you want to invest via lump sum or SIP mode.
4. Enter the amount that you want to invest.
5. Click on the payment button to complete the payment and start your investment.

Capital markets are constantly evolving, and new thematic funds are brought into existence by mutual funds to cater to the diversified interests of investors. If you are a discerning investor, you can pick out themes that can potentially become the future highlight of the financial markets. You can, then, invest in such themes through thematic mutual funds and enjoy the returns when your selected theme gains traction and captures the growth in the market.