The Hindu Business Line : Theme Funds: Optimal to custom-tailor portfolios

Alternative energy and water, for instance, are theme investments. Theme funds are available in the country, though not in plenty. Should investors carry such funds in their portfolio?

Theme vs Sector

Theme investment refers to identifying trends or themes that are likely to drive a certain group of assets. A popular theme investment is water.

A fund having such a mandate will invest in companies in the business of Water Treatment Chemicals, Pump Equipment, Water Utilities, Water Purification and Water Pipeline Construction.

Two popular theme funds offered in India are Services Sector Funds and Infrastructure Funds.

A Services Sector Fund invests in companies engaged in financial services, technology, hotels and entertainment.

The Infrastructure Fund would have exposure to companies in non-ferrous metals, cement, construction and capital goods.

A theme fund, hence, takes exposure to more than one sector. Besides, it can engage in style rotation.

A service sector fund may be overweight on, say, large-cap financial services stocks in one month and shift to mid-cap technology stocks the next month.

These factors — style rotation and multi-sector exposure – have to be considered before an investor buys such theme funds within the core-satellite framework.

The core portfolio typically carries exposure to a broad-based benchmark index such as the S&P CNX 500. It can alternatively carry exposure to a large-cap style index fund such as those benchmarked to the S&P CNX Nifty or the BSE Sensex.

Theme funds and sector funds have to be, hence, carried only in the satellite portfolio — a portfolio that is constructed to generate excess returns over the benchmark. In the article dated November 15, we discussed why sector funds are optimal for the satellite portfolio. The same argument cannot, however, be used for theme funds. Why?

Take a core-satellite portfolio that contains Nifty Index fund inside the equity core and service sector fund as part of the satellite portfolio. A significant proportion of the holdings in the service sector fund will overlap with the Nifty fund due to its multi-sector exposure, leading to unintentional overweight on stocks. Infosys, HDFC, SBI and TCS, for instance.

Theme funds in emerging industries such as water or alternative energy would, however, be optimal within the satellite portfolio, as the overlap exposure will be minimal.

The overlap between core and satellite portfolios may not be of concern if an investor can rebalance the satellite portfolio periodically. Such rebalancing could, however, suffer from exit loads. Besides, not all investors are geared to timing the market. That is why theme funds currently available in the market may not be an optimal choice for the satellite portfolio set-up to meet retirement objectives.

Such funds can, however, be used to meet short-term objectives, where the fund's theme closely matches the investor's liability structure.

Suppose an investor wants to supplement her health-care insurance with an investment portfolio.

A health-care fund that carries exposure to pharma companies, hospitals and health-care service providers would be optimal. The logic is that inflation in health-care costs would be well captured by the companies in the health-care sector.

Similarly, an investor who wants to construct a portfolio to buy a house can use the infrastructure fund to meet her liability.

Conclusion

Theme funds may be optimal within an equity satellite if overlap with the equity core is minimal.

At present, such funds can be primarily used as investments to meet liabilities such as buying a house. More varieties of such funds would enable investors' custom-tailor their portfolios to meet short-term liabilities.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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