In Favour of Focused Funds
Anil Kumar
Director, Dhrubtara Advisors Private Limited
Most investors think that risk is proportionately reduced by adding each additional stock in a portfolio, which, actually, is quite farther away from the truth. In the book titled ‘Modern Portfolio Theory and Investment Analysis’ authored by Edwin J. Elton and Martin J. Gruber, there is evidence that one can only reduce risk to a certain point beyond which there is no further benefit from diversification. According to Warren Buffett, “Wide diversification is only required when investors do not understand what they are doing.”
In simple words, if one were to diversify too much, they may not lose much, but then they won’t gain much either. In other words, adding too many stocks in the fund portfolio takes away the potential of making big gains and hence impacting the overall fund returns as we have seen happening with a large number of mutual funds that invest in too many stocks. In its re-categorization exercise by the market regulator SEBI, focused fund was put forth as one of the categories among the equity mutual fund universe.
As per their guidelines, a focused fund portfolio can consist of up to 30 stocks. This is in contrast with a diversified equity mutual fund, which typically holds anywhere between 50 to 100 stocks. Focused equity schemes are a 22-member strong club in the MF landscape with close to Rs50,000 crore investor assets, which grew by about 20 per cent year on year while a 24 per cent rise in investor folios have pushed the folio count to 3.7 million, as of July 2020.
Also, a focused fund does not have any restriction when it comes to market capitalization and is free to invest across large, mid and small-caps. However, the regulator requires such schemes to indicate where they intend to focus when it comes to portfolio construction. In India, over 20 mutual funds currently are offing this variant of equity mutual fund. By investing in a maximum of 30 stocks, the fund manager builds a concentrated portfolio of high conviction stocks to maximise gains. The benefit of following such a strategy is that the potential gains can be exponential if the high conviction stock ideas are proven right.
Similarly, if the call taken heads south the portfolio has the potential of facing steep losses. Hence it is extremely important to get the choice of a focused fund right given that returns could be volatile. Therefore, on the risk front, such schemes are riskier than diversified equity funds but are less risky than sectoral or thematic funds. One of the important elements in the process of selecting a focused scheme is to evaluate the risk management processes followed by the fund manager and his or her capability as a stock-picker. The other element which needs careful consideration is the size of the fund given the restriction on the maximum number of stocks being at 30.
Good Time for Focused Equity Funds?
Historically, strong companies have always managed to emerge stronger during times of disruption. The bounce-back in corporate earnings translates to higher stock price over a period of time. As a result, it pays to be invested in robust companies which are likely to do well, which is what a focused fund portfolio will most likely comprise of. At the same time, investors should be mindful of the fact that there could be phases where this type of fund may witness a temporary blip in performance. However, the recovery is also expected to be equally sharp.
In the light of the corona virus-related uncertainties, it makes absolute sense in placing your faith in the high-quality businesses. For a lay investor, this can be easily achieved through investing in equity mutual fund category such as the focused equity funds. On a year–to–date basis, the best performing fund in this category has delivered 6.3 per cent compared to a peer group average of – 5.1 per cent. So, be careful while selecting funds in this category as the return will be heavily impacted by the calls taken by a fund manager given the limited diversification which may exist within these 30 stocks. To conclude, if you are a long-term investor and plan to stay invested for the long term, a focused fund can be a part of your portfolio.
The writer is a Director, Dhrubtara Advisors Private Limited
Email id : dhrubtara1673@gmail.com