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Should you invest in a focused equity mutual fund?

A focused fund in structure is similar to a diversified multi-cap fund with one very important distinction – the portfolio is more concentrated than a regular diversified equity fund. But does this mean better performance?

Post the recategorization of mutual fund schemes by Securities and Exchange Board of India, there is now a new category of equity funds called focused equity fund. As per SEBI’s guidelines, this type of equity fund can have a maximum of 30 stocks in its portfolio and is generally managed as a multi-cap fund.

A focused fund in structure is similar to a diversified multi-cap fund with one very important distinction – the portfolio is more concentrated than a regular diversified equity fund. But does this mean better performance?

Concentrated portfolios are a double-edged sword given that negative performance can also be much more compared to the benchmark. Hence, one has to choose with care.

Does concentration contribute to performance

As mentioned above, a focused fund is one with fewer number of stocks in the portfolio as compared to a regular diversified equity fund. The reasoning behind a focused fund is to give returns by creating a concentrated portfolio that can have a per stock holding of 8%-10% in just a few stocks. Usually each stock will be at least 1% of the total portfolio.

Some theories suggest that a good quality concentrated portfolio can outperform the benchmark given that higher amounts are invested in single stocks which contribute to overall performance. However, a quick look at the average performance of this category shows that this is not always the case.

Out of the 17 focused equity funds, at least seven underperformed the S&P BSE 500 Index in one year rolling return and for three year rolling return, seven of 15 funds underperformed the index.

Concentrated portfolios are a double-edged sword given that negative performance can also be much more compared to the benchmark. Hence, one has to choose with care.

Higher concentration means higher risk

Beta measures the risk of a scheme versus the market risk. If you look at the beta of these focused funds it is more than 1. A beta value greater than 1 signifies that the fund carries risk which is greater than the market risk. Higher risk should ideally be compensated by higher return, however the data above shows that not to be the case at all times.

The volatility of returns, often called “variance”, in these funds is also high. This is measured by standard deviation, which shows how much the annual fund returns can potentially move away from the average return. This can be either upwards or downwards.

A high standard deviation means the funds returns can either go much higher or much lower. This in turn increases the risk of the fund moving away from your potential expected return more than you may be comfortable with.

For the focused fund category, the standard deviation of three-year returns has been observed to be 1%-2% higher than the standard deviation of the S&P BSE 500 index – which shows higher volatility in returns.

What should you do?

A focused fund is a high risk, high return choice of fund for an investor; the return can be potentially higher than the benchmark, but you should be ready to expect wide underperformance too. This is more suited for seasoned investors rather than the average individual investor who wants to focus on steady wealth creation for the long term.

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