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Do you need to focus on focused funds?

Focused equity funds follow a similar investment philosophy by maintaining a tight portfolio of not more than 30 stocks. Their aim is to hit the bull’s eye with the right stocks (bought with high level of conviction) and earn a higher return.

“Diversification is a protection against ignorance” - Warren Buffett

Financial experts often tell you to spread your investments across baskets. Or diversify your investments. 

However, unlike many Indian mutual fund managers that hold about 50 or more stocks in their portfolio, great investors like Warren Buffett and George Soros believe in keeping concentrated portfolios. 

While these investment gurus believe in the virtue of diversifying, they also think that diversifying beyond a point is meaningless and only leads to mediocre returns. 

After all, how many really good stocks can you find at a point in time in the stock market? 

So, they bet their money on few quality stocks and keep tracking and analysing their prospects in an in-depth way. 

What are focused funds?

Focused equity funds follow a similar investment philosophy by maintaining a tight portfolio of not more than 30 stocks. Their aim is to hit the bull’s eye with the right stocks (bought with high level of conviction) and earn a higher return. 

Post-reclassification of categories of equity mutual funds in 2017, there are about 20-odd focused funds in the market that follow such investment strategies. 

Should you invest in them?

Let’s look at pros and cons of focused funds.

Great start

The year 2019 has been a good year for the focused funds. In the last one year, it topped the charts among all categories of equity funds (except sector funds) by giving an average return of 18.2 percent (see chart). 


During the year 2019, the market remained polarised with equity rally being led by few stocks. And focused funds that took large positions in stocks - that led the market rally - benefitted immensely. However, such trends are unlikely to remain for a long time and might give way to a broad-based rally and thereby reduce extent of outperformance. 

Moreover, after its 2017 reclassification, there is little track record to gauge long-term performance and consistency of focused funds. 
The last year performance has been a mixed bag with some funds like IIFL Focused equity and Axis Focused 25 giving returns in excess of 26 percent, while it was in single digits for focused funds of ICICI Prudential and HDFC. 

Size issues
Smaller the asset size, more nimble-footed the fund manager can get and benefit from focused investment strategies. As of Jan 31st 2020, there were five focused funds with assets in excess of Rs 40,000 crore (See chart). 


Back-of-the-envelope calculations suggest that it requires an investment of at least Rs 1,500 crore in each stock for these big-sized funds. Not surprisingly, some of them are essentially becoming a large cap fund – due to lack of sufficient liquidity in the mid cap counters. 

High risk
Since they hold concentrated portfolios, their susceptibility to market movements is much more. Their NAVs are much more volatile than otherwise. And many of these funds have been found to have high portfolio turnovers – in excess of 100% and in some cases in excess of 1000%. Such high portfolio churning on the back of concentrated portfolio can spell disaster, if the investment calls fail. 

Higher NAV volatility of focused funds can unsettle conservative investors. They are better off investing in conventional equity funds. For those who can stomach higher risk, a portion of portfolio can be allocated to these funds. However, with lack of a long track record of performance, keep such exposures to the minimum. 

Fees
These funds, on an average, charge high expense ratio of 2.3 percent every year. High expense ratio in turn makes outperformance difficult for their fund managers.

Should I invest?
Higher NAV volatility of focused funds can unsettle conservative investors. They are better off investing in conventional equity funds. For those who can stomach higher risk, a portion of portfolio can be allocated to these funds. However, with lack of a long track record of performance, keep such exposures to the minimum. 

Takeaway
Focused funds take riskier bets by investing in fewer stocks. Some have grown very large, while others churn their portfolio a lot. Till the time there is a proven track record for these funds, prudent investors can limit the focus to conventional equity funds.  

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