Investments

Thematic and Sectoral Funds for NRIs: Concentration Risk, Tax Treatment, and Allocation Limits

NRIs investing in thematic or sectoral funds face higher concentration risk. Understand SEBI rules, tax rates, AMC restrictions, and how much to allocate.

Rakesh Sinha, NRI Finance WriterReviewed 9 May 202614 min read

In the twelve months between June 2023 and June 2024, the Nifty India Defence Index returned just over 100%. The three years before that produced similar compounding. Then the index spent the better part of a year moving sideways while the broader market continued upward. NRIs who bought defence funds at the peak are now sitting on positions that look flat against a rising portfolio benchmark.

This is the defining characteristic of thematic and sectoral funds: brilliant in retrospect, difficult in practice. They reward investors who enter early and have the patience to stay through the flat stretches. They punish investors who chase recent returns, which is exactly what most of us do.

The 30-second answer: Thematic funds invest in a broad idea spanning multiple sectors (infrastructure, consumption, digital India). Sectoral funds concentrate in a single industry (pharma, banking, technology). Both require at least 80% allocation to the stated theme or sector under SEBI rules, which creates high concentration risk. Tax treatment is identical to diversified equity funds: 12.5% LTCG above Rs 1,25,000, 20% STCG. Most US and Canada NRIs face AMC restrictions. Treat these as satellite holdings capped at 10-15% of your equity allocation. They belong in a portfolio only when you have a clear structural view on why a sector will outperform over five-plus years, not because it already has.

The Indian mutual fund industry classifies over a hundred schemes as either thematic or sectoral. For an NRI investor evaluating these funds from outside India, there are several layers to work through before making an allocation decision: the structural difference between the two categories, the concentration math, the AMC access question, the tax mechanics, and the portfolio construction logic. This guide covers all of them.

Thematic vs Sectoral: The Distinction That Matters

SEBI defines these two categories with precision, and the difference is meaningful for how you think about risk.

A sectoral fund must invest at least 80% of its assets in stocks of a single sector. Banking sector funds hold banks and NBFCs. Pharma funds hold pharmaceutical companies. Technology funds hold IT services and software firms. The remaining 20% can go into related companies or cash equivalents, but the core mandate is narrow. If the sector goes through a regulatory clampdown, a demand slowdown, or a structural disruption, there is nowhere inside the fund to hide.

A thematic fund also has the 80% minimum allocation rule, but the universe is wider because it is defined by an investment idea rather than an industry code. The infrastructure theme, for example, cuts across cement, steel, construction, engineering and capital goods, logistics, airports, ports, power generation, and transmission. An investor in an infrastructure fund is not betting on cement alone. They are betting on the overall capital expenditure cycle in India. This multi-sector spread does not eliminate concentration risk, but it distributes it across a broader economic narrative.

In practice, this distinction matters when you are comparing volatility. A banking sector fund will swing with NPA cycles, RBI policy decisions, and credit growth data in ways that a broader financial services theme fund will not, because the theme fund can hold insurance companies, wealth managers, and fintech platforms alongside traditional banks.

For NRIs building a portfolio from abroad, the thematic structure is generally more forgiving. You are still making a macro call, but you have more companies in the portfolio to absorb the variance.

Why 80% Concentration Is Genuinely Risky

The 80% SEBI mandate means that no matter what the fund manager believes about valuation, the fund cannot meaningfully reduce sector exposure below that floor. Compare this to a flexi-cap fund, where the manager can hold 20% in a sector when it looks expensive and 60% when it looks cheap.

The consequences of this rigidity showed up clearly in the IT sector between January 2022 and December 2022. Technology stocks fell 30-40% in that period, driven by US rate hikes compressing growth stock valuations and a slowdown in discretionary tech spending. A flexi-cap manager could rotate out. A technology sector fund manager had to stay invested. Investors who had allocated to tech funds during the 2021 rally sat through nearly two years of drawdown before recovering.

This rigidity also creates an unusual entry-point problem. By the time a theme becomes popular enough to attract large inflows, the easy gains are often already in the price. The infrastructure theme in India had its biggest fund launches in 2007, right before the cycle turned. The defence theme saw its biggest launches in 2023-24, after three years of exceptional returns.

The honest framework for evaluating any thematic fund entry is: would I buy these underlying companies today at current valuations, given what I know about where we are in the cycle? If the answer is yes, the fund is worth considering. If the answer is "I am buying because the one-year return looks good," that is a warning sign.

Four Structural Themes With a Genuine NRI Perspective

Not all themes are equally compelling. Below are four that have structural tailwinds over a five-to-ten year horizon, with reasoning specific to what NRIs are observing from outside India.

Infrastructure: India's infrastructure spending as a percentage of GDP has been rising consistently since 2014, with the government's capital expenditure budget crossing Rs 11 lakh crore in the Union Budget 2024-25. The National Infrastructure Pipeline envisions Rs 111 lakh crore in project investment across roads, railways, urban infrastructure, energy, and logistics through 2025. NRIs who have watched China's infrastructure transformation from the 1990s onward will recognise the trajectory. The theme is long-duration and relatively insulated from short-term earnings cycles because government capex tends to be sticky.

Banking and Financial Services: India remains significantly under-penetrated in formal credit, insurance, and wealth management relative to economies at a similar income level. Mortgage penetration as a percentage of GDP stands around 12% compared to 40-60% in developed markets. As the middle class grows and formalisation of the economy continues through GST and digital payment rails, financial services companies stand to benefit structurally. This theme has the added advantage of being the largest weight in most broad Indian indices, so investors who want to overweight financials without losing all diversification find theme funds a reasonable vehicle.

Healthcare and Pharmaceuticals: India's generic pharmaceutical industry supplies approximately 20% of global generic medicine volume by quantity. Post-COVID, the global supply chain diversification trend has accelerated demand for Indian contract manufacturing. Domestically, rising health insurance penetration is driving hospital utilisation. For NRIs living in the US or UK who have watched Indian pharma companies supply medicines used daily in their adopted countries, this is a sector they understand intuitively.

Technology and Digital: The broader digital theme in India goes beyond the IT services majors. It includes fintech platforms, digital commerce enablers, data centre operators, and semiconductor design companies. This theme is more volatile because it blends large-cap IT services (which trade on US revenue visibility) with mid-cap domestic digital players (which trade on India consumption). The theme works over a ten-year horizon but can be painful in periods of US dollar weakness or global tech sector compression.

Which AMCs Accept US and Canada NRIs

This is the most practically important question for a significant portion of NRI investors, and the answer is more complicated than it should be.

After the Foreign Account Tax Compliance Act (FATCA) came into effect, most Indian AMCs decided the compliance cost of serving US and Canada-based NRIs was not worth the business. The large fund houses, including HDFC AMC, ICICI Prudential, Axis, and Kotak, withdrew services for these investors either entirely or for new purchases.

The fund houses that have continued to accept US and Canada NRIs include Mirae Asset, PPFAS Mutual Fund (Parag Parikh), Nippon India Mutual Fund, and Quantum Mutual Fund. The acceptance is not blanket across all schemes. You need to verify scheme-by-scheme whether the specific thematic or sectoral fund you want is open for US or Canada NRI investment.

The process typically requires: an NRE or NRO bank account, a PAN card, completed KYC with the fund house's registrar (CAMS or KFintech), and in some cases a specific form for US or Canada residents that includes FATCA declarations. For NRIs in other geographies (UAE, Singapore, UK, Australia, and most of Asia and Europe), the process is simpler and most AMCs will accept investment.

For NRIs restricted from direct mutual fund investment, thematic exposure through ETFs listed on Indian exchanges, accessed via a demat account and PIS-enabled NRE account, is an alternative worth exploring.

Tax Treatment: Equity Rules Apply

SEBI's requirement that thematic and sectoral funds maintain at least 80% in equity means these funds qualify as equity-oriented funds for Indian income tax purposes. The same rates that apply to a Nifty 50 index fund apply here.

Long-term capital gains (LTCG): Units held for more than 12 months. Gains above Rs 1,25,000 in a financial year are taxed at 12.5%, with no indexation benefit. The Rs 1,25,000 exemption applies across all equity mutual fund and listed equity gains in the year, not per fund.

Short-term capital gains (STCG): Units held for 12 months or less. Taxed at 20% on the full gain, no exemption.

TDS for NRIs: This is where the practical difference from resident Indian investors shows up. For NRI investors, TDS is deducted at source on redemption. The fund house deducts 12.5% on LTCG and 20% on STCG before crediting the proceeds to your NRE or NRO account. If your actual tax liability after treaty relief or exemption is lower, you claim a refund by filing an Indian income tax return.

Double Taxation Avoidance Agreements: India has DTAAs with over 90 countries. NRIs in treaty countries may be able to claim a credit in their country of residence for Indian taxes paid. The mechanics vary by country and treaty. US-based NRIs should note that the India-US DTAA does not eliminate Indian tax on capital gains; it provides credit relief, which reduces double taxation rather than eliminating Indian tax altogether.

The Rs 1,25,000 exemption and portfolio sequencing: For NRIs who hold multiple equity funds, managing which funds get redeemed in a given year to stay within the Rs 1,25,000 LTCG exemption is a practical tax planning exercise. Thematic funds that have generated large gains are candidates for phased redemption rather than full exit in one financial year.

Switching between sectoral funds, or switching from a sectoral fund to a diversified fund, is treated as a redemption followed by a fresh purchase. Both the switch-out and the switch-in trigger tax events. This is a common mistake that inflates the tax bill unnecessarily.

Worked Example: Defence Fund Entry and Exit Math

Assume an NRI invested Rs 5,00,000 in a defence theme fund in April 2021. The NAV at entry was Rs 20. The investor received 25,000 units.

By April 2024, the NAV had risen to Rs 58, driven by the three-year defence sector run. The holding is now worth Rs 14,50,000. The gain is Rs 9,50,000.

If the investor exits in April 2024 (more than 12 months held, so LTCG applies):

Total gain: Rs 9,50,000
Exemption: Rs 1,25,000
Taxable LTCG: Rs 8,25,000
Tax at 12.5%: Rs 1,03,125
TDS deducted by fund house: Rs 1,03,125 (approximately)
Net proceeds after TDS: approximately Rs 13,46,875

If the same investor had instead stayed through the flat period that followed, and exited in April 2025 when the NAV recovered to Rs 62:

Total gain: Rs 10,50,000
Taxable LTCG: Rs 9,25,000
Tax: Rs 1,15,625
The additional year of holding added Rs 1,00,000 to the gain but Rs 12,500 more to the tax bill. The net of tax outcome was better for staying.

This example illustrates why the conventional advice to exit a theme fund when it has "run too much" is harder to execute than it looks. The tax drag on a large gain is real but rarely justifies premature exit if the structural thesis remains intact.

The Satellite Allocation Framework

Thematic and sectoral funds do not belong in the core of an NRI's India portfolio. The core should be built with diversified equity, ideally through a combination of index funds covering large-cap and mid-cap segments, possibly supplemented by one or two quality active funds. This core should constitute 80-85% of the equity allocation.

The remaining 15-20% is where thematic and sectoral funds sit, as satellite positions. Within that satellite allocation, a reasonable further constraint is to hold no more than two or three themes at any one time, and to size no single theme at more than 7-8% of total equity. This prevents a single bad macro call from materially damaging the overall portfolio.

The entry decision for a satellite position should be thesis-driven, not performance-chasing. The checklist is simple: Is there a structural reason (government policy, demographic shift, global supply chain change) that this sector should grow faster than the broad economy over five-plus years? Is current valuation in line with or below historical averages? Is the sector in favour with flows, or is it in a temporary downturn that makes valuation more attractive?

The exit decision is harder. A theme fund should be reviewed annually. If the structural thesis has changed (a change in government policy, a technology disruption, a regulatory reversal), that is a reason to exit regardless of short-term performance. If the fund has simply had a flat year while the thesis remains intact, patience is usually the right response.

A final practical note: because thematic funds tend to perform in clusters, their gains often coincide with gains in other equity holdings. Annual rebalancing, which might mean trimming a thematic fund that has outperformed and adding to the lagging core holdings, is a disciplined way to harvest concentration risk rather than letting a satellite position drift into becoming the dominant holding.

The Closing Read

Thematic and sectoral funds are not instruments for most NRI investors in most years. They are instruments for investors who have built a stable core portfolio, understand the specific structural story they are betting on, can tolerate a five-year holding horizon, and will not be tempted to exit because a calendar year return disappointed.

The defence example is instructive not as a cautionary tale but as a realistic illustration of what these funds actually do: they generate large returns during the years a theme is in favour, then test your conviction during the years it is not. The investors who captured the full defence return were not smarter than those who missed it. They had a structural view, entered early, and held through the flat period.

For NRIs, the AMC access question should be resolved first, before spending time on fund selection. If you are based in the US or Canada, your options are narrower. Work within those constraints rather than around them. For NRIs with access to the full mutual fund universe, the structural themes most worth watching for the next decade are infrastructure, financial services, healthcare, and digital, in that order of conviction based on policy support and valuation starting points.

Tax planning for these funds is manageable but requires intentionality. The LTCG exemption, TDS refund filing, and the taxable event on switches are all points where a small amount of planning saves a meaningful amount of money.

Keep satellite holdings genuinely satellite. If a theme fund starts exceeding 15% of your equity allocation because it has performed well, consider trimming rather than celebrating. Concentration that was a deliberate small bet can quietly become the dominant risk in a portfolio, and the time that becomes visible is usually after the sector has peaked.

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Disclaimer: This guide is for general informational purposes and does not constitute investment or tax advice. Tax laws and SEBI regulations change. Mutual fund investments are subject to market risks. NRI tax obligations vary by country of residence and individual circumstances. Consult a SEBI-registered investment adviser and a qualified tax professional before making investment decisions.

Frequently asked questions

Can NRIs from the US and Canada invest in thematic and sectoral mutual funds in India?

Yes, but with restrictions. Most Indian AMCs stopped accepting US and Canada-based NRI investors after FATCA compliance costs made it commercially unviable. A handful of fund houses still accept them: Mirae Asset, PPFAS, Nippon India, and Quantum are the commonly cited names, though their permitted fund list varies and can change. Before investing, you need an NRE or NRO bank account, a PAN, and a KYC-compliant folio. Confirm directly with the AMC whether the specific thematic or sectoral scheme you want accepts US or Canada NRIs, because the restriction often applies at the scheme level rather than the fund house level.

What is the tax rate on thematic and sectoral fund gains for NRIs?

Thematic and sectoral funds are classified as equity funds for tax purposes, as they must hold at least 80% in equity under SEBI rules. Long-term capital gains (units held more than 12 months) are taxed at 12.5% on gains above Rs 1,25,000 per financial year. Short-term capital gains (units held 12 months or less) are taxed at 20%. TDS applies at source for NRI investors: 12.5% on LTCG and 20% on STCG. If your home country has a Double Taxation Avoidance Agreement with India, you may be able to claim a credit for TDS paid. File an Indian tax return if you want to claim a refund for excess TDS deducted.

What is the difference between a thematic fund and a sectoral fund?

A sectoral fund concentrates exclusively in one industry: banking, pharmaceuticals, technology, or fast-moving consumer goods, for example. A thematic fund covers a broader investment idea that spans multiple sectors. An infrastructure theme fund, for instance, might hold cement companies, construction firms, capital goods manufacturers, power utilities, and logistics players. The common thread is the theme, not the industry classification. Because thematic funds spread across more industries, they tend to have slightly lower single-sector risk, but both structures require SEBI-mandated 80% minimum allocation to the stated sector or theme, which means concentration risk remains significantly higher than in a diversified equity fund.

How much of an NRI portfolio should go into thematic or sectoral funds?

Most practitioners treat thematic and sectoral funds as satellite holdings, not core positions. A reasonable cap for most NRI investors is 10-15% of the total equity allocation, split across no more than two or three themes. Going beyond 20% means your overall portfolio return becomes heavily dependent on one or two macro calls being right at the right time. If a theme underperforms for three to five years, which is common, a large allocation creates both financial and behavioural pressure to exit at the wrong moment. Start small, give the position at least one full market cycle, and only add to it if the structural thesis remains intact.

Rakesh Sinha, NRI Finance Writer

Rakesh Sinha is a technology professional and an NRI since 2016. He holds a master’s from Carnegie Mellon University and a BTech in Computer Science from IIT Guwahati, and has worked at Microsoft, Cisco, InMobi and Google across Bengaluru, the United States and London. He has personally navigated the decisions these guides cover: moving foreign salary and tech-company RSUs across borders, opening NRE, NRO and FCNR accounts, filing Indian returns as a non-resident, and claiming DTAA relief between the US, UK and India. How these guides are written and reviewed.

Disclaimer: This guide is educational and general in nature. It is not individual financial, tax, or legal advice. Tax and FEMA rules change and your situation may differ, so confirm specifics with a qualified chartered accountant or financial adviser before acting. See our editorial standards for how these guides are researched, reviewed and updated.