How can thematic index mutual funds add value to your portfolio?

In India, simple and diversified index funds have emerged as a good alternative to traditional large cap funds in recent years. Globally, the passive category has evolved over the years, moving from plain vanilla investment solutions to funds that focus on specific geographies, market segments, and multiple-factor or theme-based funds like technology, healthcare, consumption, etc.India has only recently begun exploring passive funds as a viable investment solution. However, passive funds in India are currently largely limited to market cap-based factors with only a small number of them based on other factors like quality and volatility. Hence, the need of the hour is to provide investors with an opportunity to passively invest in other categories – especially, thematic index funds that can help them achieve optimal portfolio diversification and give them the desired exposure to high conviction themes.

Thematic index funds can be an effective way to participate in promising themes like healthcare, consumption, and financial services which have structural tailwinds in the long run. A passive construct makes them true to label with 100% exposure to the stated theme/sector unlike active thematic funds where 20% can be invested outside the theme as per SEBI guidelines – a provision that active funds use extensively.

Some thematic funds also provide global exposure by investing in global assets. However, considering the varied factors that impact global assets, such funds need deep global research capabilities that might be challenging to access or build from a domestic location. Index funds ably solve this challenge by simply investing in stocks that are part of the global benchmark index, basis a predetermined investment mandate and criteria.

While thematic index funds offer myriad benefits, it is important to understand how they can add value to your portfolio. This investment solution is well-suited for investors looking for long-term strategic allocation to structurally strong themes. Moreover, it can also appeal to investors looking to leverage tactical allocation opportunities to capture mean reversion in performance – like a bounce back after long-term underperformance.

In the current scenario, the healthcare sector provides such a compelling opportunity. The theme has seen underperformance in the last five years but has the potential to generate reasonably good performance in the near future. Further, mean reversion in the sector is now becoming visible. Valuations are reasonable and growth opportunity in the sector is attractive in the long run given structural tailwinds like rising healthcare awareness, increasing instances of lifestyle disease, introduction of newer treatments,etc. A healthcare index fund would be ideal in such a scenario as it can provide low cost and undiluted exposure to the healthcare theme. Few funds may even capture global exposure which is currently missing in many active funds, butis integral in a theme like healthcare where markets like the US are instrumental in driving innovation and healthcare spends.

Investors should also be aware that thematic index funds are confined by boundaries and are suitable only for investors with medium to high risk appetite.The performance of these funds can be cyclical in nature and can endure long periods of low returns. Hence, investors must exercise patience when investing in such funds. Thematic funds generally have a low correlation with the broader markets and hence, their performance can be in divergence with the broader market.

In the coming years, as the passive journey continues to evolve in India, index funds and especially thematic index funds, can add another interesting dimension to the growth story and be a useful addition to an investor’s portfolio.

Radhika Gupta is the MD & CEO of Edelweiss Asset Management Limited (EAML). – Livemint