Sectoral and thematic flows drop to 10-month low: Why you should be worried

In a significant shift in market dynamics, domestic mutual fund inflows experienced a notable slowdown in February 2025, reaching Rs 29,000 crore, down from Rs 40,000 crore in January. This deceleration has impacted almost all categories of funds, with the sharpest decline observed in thematic and sectoral funds, signaling potential turbulence ahead for investors, noted a report by Elara Capital.

 

Slowing Down of Thematic/Sectoral Funds

The inflows into thematic and sectoral funds have drastically slowed, recording only Rs 5,712 crore in February—marking the smallest inflow in this category in the past 10 months. This decline is part of a broader trend that began in September 2024, where sectoral funds like those focused on defense, PSU (Public Sector Undertakings), and manufacturing witnessed a significant drop of nearly 75% from their peak inflows.

 

Manufacturing funds, in particular, have seen small outflows in February 2025 for the first time since 2022, raising concerns about the sustainability of these once-euphoric market sectors. While funds in sectors such as defense and PSU have yet to see redemptions, their inflows have substantially slowed, indicating waning investor enthusiasm in previously high-demand areas.

 

"The trend in Sectoral/Thematic flows has been slowing down since Sep’24 (down by almost 75% from peak) & this has been our biggest concern for themes like Defense, PSU, Manufacturing etc. which had seen the biggest euphoria. In fact, Manufacturing funds have seen outflows in Feb’25, for the first time since 2022 (quantum is still small)," said Sunil Jain of Elara Capital.

 

Redemptions have not yet started from Defense and PSU funds, but inflows have slowed down significantly, noted the report. 

 

Small-cap and Midcap flows have also slowed down in Feb’25 but they remain in line with average flows seen over the last 1-year. ETF/Index flows have been slowing down since the past 4-months largely because of redemptions from Sensex ETFs and slowdown in Nifty ETF flows. 

 

  The table shows flows into various Sectoral & Thematic funds. Largest euphoria in this cycle was in Manufacturing, Innovation, Business Cycle and Infra funds. However, most of these categories have finally started seeing a big slowdown in flows. Rather, slower outflows have already begun from Manufacturing funds.  Sectoral Fund Worries: Echoes of 2007-2008 Euphoria

The slowdown in sectoral and thematic flows, particularly after a period of intense speculation, has raised alarm bells for market analysts. The surge in funds allocated to these categories since 2020 bears a striking resemblance to the irrational exuberance observed in the market during the late 2000s. During that time, rapid inflows into specific sectors—such as technology—were followed by a sharp market correction.

 

Thematic and sectoral funds, especially those related to manufacturing and infrastructure, were previously characterized by concentrated buying that inflated stock prices across entire sectors. As of February 2025, a significant portion of assets under management (AUM) in these categories is now sitting on negative returns, and nearly 19% of thematic sectoral schemes are trading at a loss of over 10%. These trends suggest that the market may be in the midst of another recovery phase reminiscent of the period between March and May 2008, prior to the global financial crisis.

 

Sunil Jain of Elara Capital explains why he is worried about Thematic/Sector Flows since Sep’24

 

• We have been repeatedly highlighting our concern on Thematic/Sectoral funds since Sep’24 because of the resemblance of the euphoria which was last seen in 1998-2000 and 2006-2008 period.

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A rapid rise in AUM of this category has reflected excess greed in the system. The old saying is that if investors start aggressively moving into this category, return expectation from markets have reached irrational zone. Concentrated buying in select stocks (by these funds) also pull the valuations of other stocks in the sector higher, resulting in a direct and indirect impact on valuations.

 

Why is it getting worrisome now is because a big portion of Thematic/Sectoral flows came much later in the cycle and is already sitting on losses. The current ‘AUM of these funds as a % of total India’s market cap’ has surpassed 2008-2009 highs. In the previous cycle, bulk of inflows came in last 6 to 9 months before the GFC collapse.

 

 Currently, 19% of the Thematic/Sectoral schemes are trading at more than 10% loss. A similar spike was seen in 2016 and 2020 period, but it was not preceded by any investor exuberance in these schemes. In 2008, we saw the first spike in Mar’08 after which markets tried to stabilise. However, the next round of correction from May’08 created a mayhem in these stocks. Currently, we seem to be in that recovery phase (like Mar’08-May’08). Closure of schemes in this category was only visible from May’11.

 

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