Insight into a new mutual fund category: Focused Funds

The difference between a focused fund and more diversified equity funds is that focused funds have a concentrated portfolio strategy as opposed to a diversified mix of stocks / sectors in diversified equity funds. We have had a number of focused funds for the past 10 years, but there was no uniform mandate in terms of company concentration across funds. Some funds had around 25 - 30 stocks in their portfolio, while others had 50 or more stocks. As the AUM of such funds increased, the fund managers added new stocks to the portfolio.

Definition (Mandate)

SEBI, through their mutual fund reclassification circular has brought about a clear distinction of investment characteristics among different mutual fund categories. Focused Funds are equity mutual fund schemes focused on a maximum number of 30 stocks. There is no restriction on allocation across market capitalisations or industry sectors in SEBI’s mandate for Focused Funds. Therefore, Focused Funds, in terms of mandate, are like multi-cap funds with a portfolio of 30 or lesser stocks. The clarity in definition of Focused Funds will enable investors to take more informed investment decisions based on their investment needs and risk appetites.

Risk: Focused Funds versus more diversified funds

As stated previously in our blog, there are two kinds of risk in equity investments – Systematic Risk and Unsystematic Risk. Systematic Risk, also known as market risk, refers to the price fluctuation of a portfolio of stocks, with market movements. Market risk is uncontrollable and investors will have to take this risk in equity investments. Unsystematic Risk refers to price fluctuation caused by a particular stock(s) or sector(s). Unsystematic risk is diversifiable, i.e. it can be reduced substantially by investing in multiple stocks across different sectors. The biggest advantage of investing in mutual funds versus directly in stocks is that in mutual funds, the unsystematic risks are diversified (reduced) to a larger extent.

Simple finance logic says that more risk diversification is achieved through a higher number of stocks. If you have a large number of stocks in your portfolio, then the underperformance of a few stocks will have a limited impact on your portfolio returns. But if you have a concentrated portfolio, then the underperformance of just a few stocks will have a larger impact on your portfolio returns. In a Focused Fund, the exposure to a stock can be in a range of 5 to 10% of the portfolio value, whereas in more diversified funds, maximum concentration is in the 2 – 3% range. So from a stock or company concentration standpoint, Focused Funds are riskier than more diversified funds.

Suggested reading: Value investing versus Growth investing in India

Volatility and Risk

Volatility and risks are terms often used interchangeably, but in our view while volatility refers to price fluctuation (both upward or downward) of a stock or fund during a period, risk is the possibility of making a loss at the end of the investment tenure (i.e. when you sell). Prices of even high-quality stocks may be volatile in the short term due to a variety of factors, but they eventually bounce back over a longer investment horizon.If the stock selection is good, intermittent volatility notwithstanding, focused funds can generate good returns over long investment tenures.

Can Focused Funds deliver higher returns than more diversified funds?

Usually, a mutual fund scheme’s outperformance versus market benchmark (also commonly known as alpha) is attributable to the performance of a few stocks. If these stocks have higher weights in the fund portfolio, then the magnitude of outperformance is larger. If we look at Nifty performance over the last 1 year, a few heavy-weight stocks have largely driven Nifty performance. The mandate of a more diversified fund will prevent having high concentrations in individual stocks, but a Focused fund can have considerably higher exposure to stocks or sectors that generate alphas.

Did you know the different performance parameters of equity mutual funds: Alpha or Beta

Select Focused funds with strong fund manager track record

Since stock selection has a bigger impact on returns for Focused funds, investors should select schemes managed by fund managers with a good track record. The fund manager’s ability to identify stocks that will perform well in the future and avoid stocks that may underperform has a bigger impact on Focused fund returns compared to more diversified funds. You should select schemes whose fund managers have beaten the market benchmark over long investment horizons, covering several market cycles.

Conclusion

In this blog post, we’ve discussed Focused funds and in what respects, from an investor perspective, they are different compared to more diversified funds. We’ve covered risks, the importance of the fund manager’s track record and have tried to highlight the difference between risk and volatility. Focused funds have the potential to generate superior returns, but investors need to have a long investment tenure for these funds. In our view, diversified funds should form the core of your mutual fund portfolio, but you can add a few Focused funds (in the right proportion) to enhance your long term returns. Investors should consult with their financial advisors if Focused funds are suitable for their investment needs.