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Recently, an auto sector fund chose to change its investment objective and convert into a transportation and logistics fund. So instead of investing in stocks of companies engaged in just the automobile and auto ancillary industries, the fund will now invest in a broader range of stocks; in other words, it has opted for an altered (read wider) investment universe.

It must be mentioned that the fund in its present avatar has been in existence for a little over 4 years and has an indifferent track record to show for.

Then there is a basic industries fund which regularly features among the top performers. However, what isn't commonly known is that the fund has a dubious track record of having altered its investment objective several times. Each time, the change resulted in an expanded investment universe.

And the instances listed above are two among several. The constraints of managing funds that invest in a select few sectors can often prove to be demanding for fund houses. As a result, it isn't entirely uncommon to find a sector/thematic fund changing/expanding its investment objective/style in due course. This bears testimony to the intrinsic inadequacy of a sector/thematic fund in terms of sustainability over the long-term. Nonetheless sector/thematic funds continue to be launched at regular intervals. Now isn't this dichotomy interesting.

Why sector/thematic funds are launched

While the most obvious answer would be -- to capitalise on attractive investment opportunities in that sector/theme, there is often more to it than meets the eye. Experience suggests that fund houses find it rather easy to garner monies in new fund offers (NFOs) as opposed to existing funds. Maybe, it's something to do with the Rs 10 net asset value (NAV) that attracts investors; then again, it could be the result of the higher commission payouts on NFOs vis-a-vis existing funds.

In most cases, with the exception of the investor, the NFO works out to be a lucrative option for all the other entities. And what could be a better excuse to launch an NFO than, invest in the 'next big story'.

Then again, investors need to shoulder some responsibility for the sector/thematic funds phenomenon as well. Every time there is a buzz around a new investment opportunity, investors feel the urge to participate therein, irrespective of its credibility. Often, they even fail to evaluate the aptness of the investment opportunity in their portfolios. This leads to their whole-hearted participation in sector/thematic funds.

But the trouble is...

A single sector or a theme is bound to run out of steam in due course. And thanks to the restrictive nature of sector/thematic funds, the fund manager has no alternatives for making investments. By restricting the investments to a sector/theme, the fund contravenes the very grain of mutual fund investing i.e. diversification. In effect, such funds make for perfect high risk-high return investment propositions.

So long as the underlying sector/theme experiences a purple patch, the funds are capable of delivering superlative performances. However, on the downside, they are found wanting. Statistics suggest that while sector/thematic funds can outperform diversified equity funds over the short-term, over longer frames diversified equity funds score better across the risk and return parameters.

Of course, there's always the option of the fund 'turning over a new leaf' and altering its investment style/objective. That isn't what you bargained for in the first place. Every fund is included in the portfolio to play a specific part; a fund undergoing a metamorphosis is certainly not an acceptable proposition.

And the solution lies in...

It's not really difficult to guess, is it? Given that a sector/thematic fund's biggest shortcoming is lack of diversification, the solution lies in opting for a well-managed diversified equity fund. And let's not forget that a diversified equity fund can invest in the sectors/themes targeted by sector/thematic funds.

Hence, investors do not miss out on attractive investment opportunities targeted by the latter. Of course, when the tide turns, diversified equity funds can seek investment opportunities elsewhere, unlike sector/thematic funds.

What investors must do

To begin with, investors would do well to understand the rather unique investment proposition offered by sector/thematic funds. Such funds are best suited for informed investors who have a view on the underlying sector/theme; the same will enable them to time their entry into and exit from the funds.

Others would do well to steer clear of sector/thematic funds and invest in well-managed diversified equity funds with proven track records over longer time frames. Sector/thematic funds can account for a smaller portion of their portfolios (if at all), in line with their risk profiles and other holdings.