The investor's fancy with thematic funds continues unabated. Despite the higher risk associated with thematic funds (compared to diversified equity funds) investors choose to focus on the higher returns that certain thematic funds like infrastructure funds have registered over the last couple of years. Surprisingly, diversified equity funds on the other hand are perceived as unable to identify themes like infrastructure and hence the need to invest in thematic funds instead.
Before investors rush to defend infrastructure funds by advancing figures to establish the wealth they have generated for investors over the latest stock market rally, we would like to draw their attention towards some very pertinent points:
1) Read the offer documents of most thematic funds and it becomes obvious that the fund manager does not have a great deal of confidence in the theme. For instance, a lot of thematic funds usually have a provision to invest a significant portion of their net assets (at times as high as 30%) outside the theme. We have a question for the fund manager over here why invest outside the theme at all if there is so much potential in the theme? We won't wait for the fund manager to answer because there can be two probable reasons. One, investing in just one theme can prove fatal when the theme runs out of steam and valuations have peaked; so diversifying a portion of the assets across other sectors/themes could prove useful. Two, there may just not be enough companies in the theme to populate an entire portfolio and hence the provision to diversify across other sectors/themes.
In our view both these reasons detract from the theme, rather from the confidence of the fund house in the theme. In our view, if the fund house is so confident of the theme, then, he should invest 100% of assets only in that theme, why diversify across other themes? On the other hand, if the fund is anyways going to target more than one theme, investors might as well opt for a diversified equity fund, which will also be investing across themes.
2) Investors who maintain that being predominantly in a theme is a good thing need to consider one point the downturn. What happens when the market witnesses a sustained downturn or when valuations in the theme have peaked according to the fund manager's estimate? Does the fund manager have the liberty to abandon the theme and pursue another theme, which in his view is more attractive than the present one? No, it will take a brave fund manager to admit that he has become a victim of his own (misplaced) enthusiasm and must now bide his time until there is a revival in that theme's fortunes.
3) Of course, it's not like the thematic fund manager is helpless in the face of a downturn in the theme's fortunes. In fact a resourceful fund manager is unlikely to be sitting idle twiddling his thumbs waiting for a turnaround in the theme's fortunes. Because if he does that, he will have a tough time justifying the fund management fees. Then there is the problem with investors going up in arms against the fund house for drawing them into a thematic fund which they knew would see a downturn that would take a long time to reverse (if they did not, then it's a poor comment on their research processes). So it's not easy being the fund manager of a thematic fund during the downturn. Don't believe us? Ask those fund managers who launched technology/media/telecom funds (or the TMT funds as they were called then) with much fanfare in 1999-early 2000. How many of these TMT funds exist today? Very few and even then mainly in name. The rest have changed their mandates to take on a more diversified avatar targeting technology/media/telecom among other sectors/themes.
In our view, the current lot of thematic funds could well go the same way, when the theme finally loses steam. If the thematic is indeed eventually destined to undergo a metamorphosis and be converted into a diversified equity fund, wouldn't it make more sense to save yourself all the agony and be invested in a diversified equity fund at the outset?
4) For all their growth prospects, the themes (and funds based on them) perform only in patches. When the theme is on the upswing, funds targeting that theme are also likely see a surge in their performance (provided the fund manager identified the theme earlier on). However, like we mentioned, it's tough being the fund manager of a thematic fund during a downturn in the theme's fortunes. Over a market cycle, thematic funds erode rather than create wealth. Don't believe us, check out the performance of thematic funds like software funds over the last 5 years and compare them with diversified equity funds. Well-managed diversified equity funds have added considerably more to the investor's wealth compared to thematic funds.
If thematic funds can rise so sharply during an upturn and still give a lower return over a market cycle, it tells you something about the money they can lose during a downturn. Thematic funds could lose so much money during a downturn, that they could forfeit all their gains of the upturn. We already saw this in the tech crash in 2000 when some software funds took several years just to reach the par value (Rs 10) let alone clock growth for investors!
5) While the performance of thematic funds may be impressive, investors ignore the fact that diversified equity funds are equal to the task of identifying themes/sectors that can deliver growth over the long-term. But more importantly they can also exit that theme/sector when it no longer holds promise. Thematic funds cannot do that. So diversified equity funds can do what thematic funds do; however the opposite is not true. Hence prudence demands that investors go for the diversified equity fund for its flexibility rather than the inflexible thematic fund.
6) Investors who are captivated by a particular theme like infrastructure are perhaps depriving themselves of the opportunity to fully capitalise on the India Growth Story, which among other sectors/themes also embraces outsourcing, consumption, finance and pharma. However, an infrastructure-centric fund will not participate in these themes some of which could well do better than infrastructure over the long-term. Of course, there is no way to find out for sure, which is why it is imprudent to commit to a particular theme and in the bargain exclude other themes. It's best to invest in diversified equity funds that can invest in several promising themes rather than just one theme.
7) Over time thematic funds have got more innovative to tackle the issue we have raised in the previous point. They have the mandate to invest in more than one theme at a time, so as to give the fund manager some flexibility. For instance, we now have thematic funds that target multiple themes like housing and finance or infrastructure and services. In our view, this only reiterates the fact that there is nothing to replace diversification. If the fund is anyways going to target more than one theme, investors might as well opt for a diversified equity fund, which will also be investing across themes.
8) Of course that is not to say that thematic funds can never prove beneficial to any investor. Thematic funds can add value to the smart investor's portfolio provided he has a view on the underlying theme and can redeem his investments when valuations in the theme have peaked. This is necessary because like we pointed out, the fund manager will not be able to exit the theme (since he is mandated to remain invested in it), so the onus to exit the theme shifts to the investor. For this the investor must have adequate research/information on the theme. This goes against the grain of mutual fund investing which dictates that the fund manager manages money for the investor so that the investor does not have to commit time and resources towards fund management especially since he is paying a fee for the same. However, investors who are confident of their ability to track the theme and make a timely exit can invest a portion of their assets (not more than 10%) in thematic funds.
It must be evident to the investor that while thematic funds can add value, the risk of losing all those gains in a downturn is significant. The investor is better off not betting on a particular sector/theme to the exclusion of other themes. Rather prudence demands that he let the fund manager of a diversified equity fund take this decision and bet on the most promising sectors/themes. In our view, regardless of the blistering performance of thematic funds like infrastructure funds, the case to invest in diversified equity funds instead continues to be as compelling as ever.
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johnd370@gmail.com
Jul 18, 2014
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johnd723@gmail.com
Jul 18, 2014
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