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Passive investing, characterised by its low-cost approach and reliance on market indices, has gained immense popularity among investors seeking a long-term, low-maintenance strategy. While traditional index funds and exchange-traded funds (ETFs) often track broad market benchmarks, investors may also consider incorporating sectoral or thematic funds into their portfolios.

Understanding Sectoral and Thematic Funds

Sectoral and thematic funds are specialised investment vehicles that focus on specific sectors or themes within the market. Sector funds concentrate on a particular industry, such as technology, healthcare, or energy, while thematic funds revolve around broader trends or concepts, like clean energy, consumption, or infrastructure. These funds provide investors with the opportunity to gain targeted exposure to areas of the market that align with their convictions or expectations for future growth.

Passive Investing and Diversification

Passive investing, as exemplified by traditional index funds, relies on diversification across a broad array of assets to mitigate risk. While sectoral and thematic funds may appear to deviate from this diversification principle, they can still play a valuable role when approached thoughtfully. The key lies in understanding how to integrate these specialised funds without compromising the core tenets of a well-diversified portfolio.

Strategic Allocation

Strategic allocation involves the inclusion of sectoral or thematic funds in a portfolio to enhance exposure to specific areas of the market. Investors must carefully assess their risk tolerance, investment goals, and market expectations when deciding on the allocation percentage for these specialised funds. While conventional wisdom often emphasises broad diversification, strategic allocation recognises that certain sectors or themes may outperform the broader market in specific economic conditions.

One way to use strategic allocation can be by developing a portfolio using the core and satellite approach, where the core or majority investment is in the broader market. Then, a smaller portion of the portfolio, the satellite part, is in sectoral or thematic investments.
For example, during a technology boom, investors may find themselves increasingly investing in tech names to cash in on the current trend playing out. However, such an approach can lead to overconcentration, and could increase portfolio volatility. A prudent approach here would be to dedicate a certain portion of the portfolio to sectoral or thematic tech funds while maintaining a core of diversified, broad-market index funds or ETFs.

An aggressive investor can create a satellite portfolio comprising a few sectoral and/or thematic funds. Invest in each sector/theme in a defined manner and rebalance among them as and when required. However, to do so, one would require monitoring of the sector/theme and the factors that influence their outlook. In effect, while the asset allocation of the portfolio is active, the stock picking is passive. Another option is to invest in an offering which actively manages thematic/sector allocation with a portfolio but by using passive instruments. This is where strategies like the Passive Strategy Fund which has a fund of fund structure comes in.

Key Points to Consider

Passive investors often follow a buy-and-hold strategy, allowing their portfolios to track the market over time. However, incorporating sectoral or thematic funds requires periodic rebalancing to maintain the desired asset allocation. Rebalancing ensures that the portfolio remains aligned with the investor’s risk tolerance and long-term objectives. For instance, if a sector experiences significant outperformance and becomes a larger portion of the portfolio than intended, rebalancing would entail booking profits to restore to the original allocation.

Another point to consider is that the sectoral and thematic funds will introduce a higher level of risk compared to traditional broad-market index funds. Investors must conduct thorough due diligence on the specific sectors or themes they intend to invest in, understanding the associated risks and potential rewards.

Conclusion

By adopting a thoughtful and disciplined approach to strategic allocation, regular rebalancing, and risk management, investors can harness the benefits of these specialised funds while maintaining the core principles of passive investing. Remember that while sectoral and thematic funds can offer targeted opportunities, a well-diversified foundation remains essential for long-term success in the dynamic world of investing.

The author is Principal- Investment Strategy, ICICI Prudential AMC. Views are personal.

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