Sectoral and thematic funds: Are they worth it for retail investors?

Retail investors should invest in sectoral or thematic funds only after building a core corpus.

Indian investors are in the middle of a thematic frenzy and are piling into infrastructure PSUs, manufacturing and anything that has delivered dazzling returns in the recent past. But behind the surge lies a familiar driver: sentiment, not strategy.

Consider this: The total NFO (New Fund Offer) collection in October stood  around Rs 6,062 crore, of which sectoral and thematic mutual funds accounted for roughly Rs 2,489 crore, contributing about 41 percent of the overall inflows.  In October, sectoral and thematic mutual funds received a total inflow of Rs 1,366 crore, compared to an inflow of Rs 1,220 crore in September.

“There isn’t any fundamental shift in investor behaviour here; it’s more about sentiment. Investors tend to chase short-term performance, and that’s what we’re seeing now. Over the past year-to-year and a half, overall market returns have been largely flat, and many investors who missed earlier rallies are now reallocating towards sectoral and thematic funds, hoping to capture near-term gains,” says Swapnil Aggarwal, Director, VSRK Capital, a SEBI (Securities and Exchange Board of India)-registered wealth management company.

Investors are undoubtedly chasing short-term performance after seeing stellar returns in themes like infrastructure, PSUs, and manufacturing.

In fact, ICRA data from 2024 shows that 80 percent of the top 10 funds and about 43 percent of all such funds had underperformed their benchmarks over the past year.

“While the trend reflects a smarter, more focused investment approach, it carries risks. The concentration in cyclical sectors makes diversification essential for long-term stability, as experts rightly caution,” says Soumya Sarkar, co-founder, Wealth Redefine, an AMFI (Association of Mutual Funds of India)-registered Wealth Management Company.

Typically, retail investors enter these segments when a sector has already performed well. However, instead of focusing narrowly on themes, it’s important to remember that opportunities exist across small-cap, mid-cap, and large-cap spaces; every sector has its own growth cycle.

Dynamic strategies outshine pure large-cap bets

Inflows into large-cap funds showed a decline in October. The dip in large-cap inflows and the steady rise in flexi-cap investments suggest investors are becoming more comfortable with measured risk-taking. Flexi-cap funds give fund managers freedom to switch between large-, mid-, and small-cap stocks, depending on market conditions, offering both growth and stability.

This indicates investors expect continued market momentum but want flexibility to capture opportunities beyond the large-cap space.

“The trend also shows a belief that broader market participation especially from mid-caps and emerging sectors will drive future returns. In short, investors remain optimistic but are preferring dynamic strategies over pure large-cap exposure,” says Sarkar.

Auto, consumption, banking and financial services are some sectors with long-term growth potential. “While consumption and BFSI (Banking, Financial Services and Insurance) haven’t done well in the past 2-3 years, with recent changes in policy like taxation. They will become major beneficiaries. Another sector that has been muted is tech and innovation that investors can look at,” says Kothari.

Meanwhile, we have also seen overweight allocation in PSU and defence funds, which have seen sharp rallies and may face corrections.

Tiny slice of your portfolio

Retail investors should invest in sectoral or thematic funds only after building a core corpus. “This should in fact be a self-imposed eligibility criterion to invest in themes only after a few years of investing experience and developing some market knowledge,” says Manish Kothari, CEO and Co-Founder, ZFunds, a mutual fund platform. Before entering, they should assess valuations, sector earnings outlook, government or policy support, and past 2-3 year returns.

“We have seen that these sectoral themes are cyclical, and low-past returns have led to outperformance in the future,” he adds.

For a retail investor, deciding to enter a sectoral fund requires caution, especially after a rally. ‘First, understand the theme's long-term potential. Is it driven by structural trends like India's manufacturing push or just short-term hype? Avoid chasing past returns,” says Sarkar.

Second, check valuations. After a rally, a sector may be overvalued and prone to a correction. Use parameters like price-to-earnings (P/E) ratios compared to their historical average.

To reiterate, never make it your core investment. “Allocate only a small portion of your portfolio (say 5-10 percent) that you are willing to risk. These funds are for tactical bets, not foundational wealth building. Ensure you have a well-diversified equity portfolio first,” says Sarkar.

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Stability at the base, strategy at the edges

Investors should focus on diversification across broad categories rather than overloading their portfolio with multiple sectoral or thematic funds. Holding more than 4–5 funds can dilute overall returns. Sectoral or thematic funds are essentially subsets of broader categories like small-cap, mid-cap, or large-cap, and concentrating too much in one sector increases risk.

An investor's portfolio should be built like a pyramid. The broad, sturdy base must consist of diversified funds like flexi-cap and large-cap, which form the core (e.g., 80-90 percent) for steady long-term growth.

“Sectoral or thematic funds are the satellite, tactical layer (e.g., 10-20 percent). Use this smaller portion for targeted bets on high-conviction themes while also accepting their higher volatility,” says Sarkar.

This core-satellite approach ensures balance. The diversified core manages risk and captures overall market growth, while the satellite portion aims for alpha from specific sectors. This strategy prevents over-concentration and allows you to participate in thematic stories without jeopardising your long-term financial goals. Also make sure you regularly rebalance to maintain this allocation.