Due to a polarised market in the recent past, focused funds, which bet on high conviction stock ideas by holding a concentrated portfolio of up to 30 stocks are gaining investor attention. The focused funds category has received inflows worth Rs 7,689 crore year to date.
As on October 2020, there are 24 focused funds in the industry with collective assets worth Rs 54,256 crore, which is 7% of the industry’s total Rs 7.77 lakh crore open-ended actively managed equity mutual fund assets. Recently, Invesco and HSBC launched focused funds which collected Rs 602 crore and Rs 509 crore, respectively.
Role of diversification
Diversification reduces risk by spreading investments across asset classes – debt, equity, gold, alternative assets, and so on. Assume your client had invested 100% of his/her savings in Indian equity funds, the portfolio would have seen a correction of 30% during the March 2020 crash. If the same portfolio was spread across gold, debt, equity, cash, and international assets, the portfolio could have witnessed a less negative impact. In technical terms, your clients should hold assets that have low corelation with each other.
Your clients need to diversify even within an asset class too. For instance, your client needs to hold different kinds of equity funds (domestic, international) and funds that are unique and in sync with the risk profile and investment horizon of the client. All funds have different investment strategies and risk-return payoff. A fund manager’s style of investing and his/her view on different sectors/companies (value, growth, momentum) also plays a part in portfolio performance. Thus, diversification across fund houses and fund managers is essential.
Concentration versus diversified
Authors Frank Reilly and Keith Brown in their book Investment Analysis and Portfolio Management, noted that in one set of studies for randomly selected stocks, "…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks." If you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio. Their theory states that if you are properly diversified, on average, you would get the same return in the market as if you had bought a passive market index. If you want to beat the market, you have to own less number of stocks but you also end up increasing your risk.
This theory perfectly sums up what focused funds try to achieve. By design, these funds are mandated to hold up to 30 stocks. They hold a diversified portfolio of stocks across sectors and market capitalisation. But the concentration in the top ten stocks could be above 60% in some funds. This means a high risk-return trade off.
When we looked at the performance of focused funds over a one-year period, there was a huge divergence in the performance of individual funds. For instance, one fund has delivered -6% return while the other has topped the category return with 16% return. Overall, the category average return of focused funds stood at 7.5% over one year period and 10.15% over a five year period.
While such divergence of performance is found across other categories of funds as well, the view of the fund manager becomes extremely important in focused funds since they tend to take concentrated bets. A few large concentrated exposure to stocks which do not play out as per the manager’s thesis could severely impact the fund’s performance.
Common Holdings
A client may end up owning several funds from different categories across fund houses without truly knowing if the portfolio is well diversified. One of the ways to check portfolio overlap is by assessing the common holdings of the schemes your clients hold. If two schemes have high common holdings, one can replace one of the funds with another scheme.
Are advisers recommending focused funds?
Portfolio management services offer highly concentrated strategies with exposure to 10-15 stocks for high net worth individuals. Mutual funds offer a similar strategy to retail investors through focused funds, presenting an opportunity to invest in high conviction bets with a much lower ticket size and cost compared to PMS.
Due to regulatory constraints, mutual funds are permitted to hold up to 10% in a single stock. Thus, when Reliance Industries Ltd., which has the highest weight in Sensex rallied, many fund managers could not increase their exposure in addition to 10% to benefit from it. On the other hand, PMS does not have this restriction.
Financial advisers caution that focused funds carry high risk and only recommend them to clients who understand the risk. “Focused funds are for informed investors as could be more volatile than other diversified funds. Investors should have the capability to digest the volatility. Focused funds are like a double-edged sword. Those who can withstand the risk can go for it and the rewards will be much more than a normal diversified fund,” says Bengaluru-based MFD Srikanth Matrubai.
Focused funds can work in a polarised market when only a few stocks are driving the index up. But advisers say that it is hard to predict which stocks could drive the market. “Towards which stocks or sectors the market may polarize in the future is unknown. Hence, I don't think it is wise to rely on past data and bet on the future especially when you are creating a concentrated risky profile,” says Registered Investment Adviser Basavaraj Tonagatti.
Focused funds could deliver higher returns in comparison to diversified funds over certain periods. But this could also backfire when the tide turns against you. “If you have realistic expectations from your investments and unsure of which sector or stocks perform well, then it is always better to have a well-diversified portfolio than a concentrated portfolio. For a few days or years, Focused Funds returns may look attractive due to the concentrated risk and performance of few stocks within those 30 companies. But betting on that is highly risky. Hence, I suggest a well-diversified portfolio than a concentrated portfolio,” recommends Basavaraj.
