Your Questions Answered: I want to invest in defence mutual funds. Please elaborate on pros and cons

Q. I am a senior manager at a private bank in Indore. My wife is an interior designer. We have been investing in large-cap mutual funds for the past 8 years. However, we wish to now diversify our investment portfolio and invest in thematic mutual funds. Many of our friends have suggested investing in defence mutual funds. Can you please elaborate on the pros and cons of investing in defence mutual funds and explain what thematic mutual funds are?

Omprakhash Khateek, Indore, Madhya Pradesh

Thematic mutual funds

Thematic mutual funds have emerged as a popular investment choice for those looking to capitalise on specific trends or sectors. Unlike traditional mutual funds that diversify across a broad market index, thematic funds concentrate on a particular theme or trend, offering investors a targeted investment strategy.

Thematic mutual funds are designed to invest in stocks that align with a predetermined theme. These themes could range from technological advancements, such as artificial intelligence and clean energy, to demographic shifts like ageing populations. The objective is to leverage the growth potential of industries or sectors that are poised to benefit from these megatrends. In India, thematic mutual funds have also gained traction, with a variety of funds available that cater to different themes.

For instance, an infrastructure theme fund may invest across sectors like cement, power, and steel, which are united by the infrastructure development theme. It’s important for investors to understand that while thematic funds can provide high returns, they also carry a higher risk as their performance is tied to the success of the chosen theme.

The Securities and Exchange Board of India (SEBI) plays a crucial role in the categorization and rationalisation of mutual fund schemes. In a circular dated October 6, 2017, SEBI introduced guidelines for mutual fund categorization, aiming to enhance clarity and uniformity across mutual fund schemes. 

The circular outlines five categories of mutual funds: Equity, Debt, Hybrid, Solution Oriented, and Others, with thematic funds falling under the ‘Equity’’ category. Thematic mutual funds are mandated under law to invest at least 80% of their corpus in companies pertaining to their selected theme.

What are defence mutual funds?

Defence mutual funds represent a specialised investment strategy that focuses on the securities of companies in the defence sector, which includes military and homeland security. They are a subset of thematic mutual funds. These funds offer investors an opportunity to gain exposure to a sector that plays a crucial role in national security and benefits from government defence spending.

Defence mutual funds are composed of a portfolio of stocks from companies that are primarily engaged in the research, development, manufacture, or sale of products and services related to defence and military operations. This sector is known for its stability and growth potential, driven by consistent government budgets allocated to defence spending.

Pros and cons of investing in defence mutual funds

Pros

Defence mutual funds in India have emerged as a compelling avenue for investors seeking to bolster their portfolios with a sector that exhibits resilience and growth potential. Here’s an exploration of the advantages of investing in defence mutual funds in India.

• Robust government backing: The Indian government’s unwavering commitment to bolstering national defence capabilities has translated into increased budget allocations and policy support. There has been a continuous increase in India’s defence budget year after year. The sector’s financial bedrock is stronger than ever. This governmental thrust not only underscores the sector’s stability but also signals sustained growth, making it an attractive proposition for mutual fund investments.
• Growth trajectory and self-reliance: India’s defence sector is on an upward trajectory, with defence production turnover surpassing ₹1 trillion, marking a significant year-on-year growth. The ‘Make in India’ initiative and the push for Aatmanirbharta (self-reliance) in defence manufacturing have opened up new vistas for the sector. This growth is not just limited to public enterprises; private companies are also scaling up, thanks to an increase in defence licences issued by the government.
• Impressive market performance: The Nifty India Defence Index, which tracks the performance of listed defence companies, has delivered a compounded annual growth rate of 54.80% in the past 5 years, outperforming the Nifty 50. This impressive return profile is a testament to the sector’s robustness and its potential to create wealth for investors.
• Diverse exposure: Defence mutual funds offer investors exposure to a wide array of companies within the defence sector, including those involved in the missile program, aerospace industry, and naval/marine capabilities. This diversification within a specialised sector helps spread out risk while capitalising on the industry’s growth potential.
• Innovation and technological advancements: The defence sector is at the forefront of technological innovation, with advancements in areas such as cybersecurity, unmanned systems, and artificial intelligence. Investing in defence mutual funds allows one to be part of this cutting-edge ecosystem, potentially reaping the benefits of technological breakthroughs and innovations.
• Export potential: India’s defence exports have been on the rise, with the government setting ambitious targets to increase these figures significantly in the near future. This export potential not only boosts the sector’s revenue streams but also enhances the attractiveness of defence companies for investment.
• Stable and predictable cash flows: Companies within the defence sector often boast strong order books, providing visibility of future cash flows. This stability is a key factor for investors seeking predictable returns over the long term.

Cons

Investing in mutual funds that focus on the defence sector in India can be an attractive proposition for those looking to diversify their portfolio and capitalise on the growth of the Indian defence industry. However, like any investment, there are several cons that investors must consider before committing their capital.

• Sector specific risks: Defence mutual funds are subject to sector-specific risks that can affect the performance of the investments. Changes in government policies, defence spending, and geopolitical tensions can significantly impact the sector. For instance, a reduction in defence budget allocation or delays in procurement processes can adversely affect companies within the fund’s portfolio, leading to potential losses for investors.
• High volatility: The defence sector can be highly volatile, with stock prices fluctuating based on defence contracts, government decisions, and international relations. This volatility can lead to unpredictable fund performance, making it a higher-risk investment option compared to more diversified mutual funds.

Investment options

Several mutual fund houses in India offer exposure to defence stocks. In 2024, more defence mutual funds were launched. Fund houses including Kotak Mutual Fund, HDFC Mutual Fund, Invesco Mutual Fund, DSP Mutual Fund, and ITI Mutual Fund are among those that offer defence mutual fund schemes. These funds invest in a mix of large-cap, mid-cap, and small-cap companies, providing a diversified portfolio within the defence sector.

Additionally, certain mutual fund houses have also launched ETFs in the defence space. It is important to understand here that the ETF is a sub-category of mutual funds. The primary characteristic of an ETF is that its units are listed on the stock exchange. The Groww Nifty India Defence ETF, allows investors to invest directly in a basket of leading defence companies. This ETF tracks the Nifty India Defence Index and offers exposure across various market capitalizations, ensuring a broad-based investment in the sector.

Performance and returns

All defence mutual funds in India have been launched in 2024. Potential investors do not have data on past performance of these mutual funds to assess their performance. However, as mentioned above one can look at the performance of Nifty India Defense Index in order to assess the growth in the defence sector.

The Nifty India Defence Index, as mentioned above, has delivered a compounded annual growth rate of 54.80% in the past 5 years, in the past year it has given a return of 103.44% outperforming the Nifty 50 (all data as on September 30, 2024).

Taxation of investments in defence mutual funds

The Union Budget 2024 has introduced pivotal changes in the taxation of mutual funds, including those invested in the defence sector. These changes are poised to significantly impact investors’ decisions and the attractiveness of mutual funds as an investment vehicle.

Understanding the new tax regime

The budget has revised the long-term capital gains (LTCG) tax rate for equity-oriented investments, which now stands at 12.5% from the previous 10%, effective from July 23, 2024. This hike in the LTCG tax rate is applicable across the board, including defence mutual funds, which are often equity-oriented due to their investment in defence and aerospace companies.

Furthermore, the short-term capital gains (STCG) tax on units of equity mutual funds has risen from 15% to 20%. This increment will affect those investors who prefer to trade their mutual fund units within a short investment horizon.

Categorisation and holding periods

Post-budget, mutual funds are categorised for taxation based on their portfolio composition and holding periods. Equity mutual funds, including defence mutual funds with more than 65% portfolio in Indian stocks, will be classified as such. The holding period for these funds to qualify for LTCG is more than 12 months. Any period less than that will be considered under STCG.

Impact on defence mutual funds

Defence mutual funds, which primarily invest in companies engaged in defence and aerospace sectors, are likely to be classified as equity mutual funds for taxation purposes. Given the increased LTCG tax rate and the abolishment of indexation benefits, investors in these funds need to brace for a higher tax outlay on their long-term investments.

Strategic adjustments for investors

Investors holding defence mutual funds must reassess their investment strategies in light of the new tax regime. It may be prudent to consider a longer investment horizon to benefit from the slightly increased LTCG exemption limit, which has been raised to ₹1.25 lakh per annum from ₹1 lakh. Additionally, investors should consult with financial advisors to understand the implications of these changes on their overall investment portfolio and tax liability.

The Union Budget 2024 has undeniably altered the landscape for mutual fund taxation, with defence mutual funds being no exception. Investors must navigate these changes with a clear understanding and strategic planning to ensure their investment decisions remain sound and tax-efficient. As the financial year progresses, staying informed and seeking professional advice will be key to adapting to the new tax environment.

Conclusion

Thematic mutual funds offer a unique opportunity for investors to engage with specific market trends. As with any investment, it’s essential to weigh the potential risks and rewards and to consider the long-term implications of investing in thematic funds. Defence mutual funds and ETFs offer a unique investment opportunity in a sector that is integral to national security and technological innovation.

By carefully selecting the right fund or ETF, investors can potentially benefit from the stability and growth prospects of the defence industry. However, it’s essential to conduct thorough research and consider the associated risks before making any investment decisions.

Kuvera is a free direct mutual fund investing platform. Unless otherwise stated data sourced from BSE, NSE and kuvera.