Should you invest in focused funds?

Most PMSes in India typically have 15-20 stocks, while focused funds on an average hold 20-30 stocks. This is against 50-60 stocks that a diversified mutual fund portfolio (read as flexi cap funds) holds in India.

“A portfolio of fewer than 20 stocks will have a higher concentration risk and for portfolios with more than 30 stocks, the diversification benefits narrow down significantly. Anywhere between 20-30 stocks is a sweet spot and a well-managed focused fund can deliver better returns with a slightly higher risk,” said Trideep Bhattacharya, chief investment officer – equities at Edelweiss Mutual Fund, who is managing its recently launched Focused fund.

In this story, we look at how focused funds fare against the diversified portfolios of flexi-cap funds and PMSes following the multi-cap strategy. All these categories can invest across large cap, mid cap and small cap stocks with no restriction and are comparable. As the portfolios of both flexi and focused mutual funds would have undergone a significant change post- the categorization rules announced by market regulator Sebi in 2017, the entire analysis is considered only from calendar year 2018.

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Focused vs flexi cap funds

The data on category average returns of flexi cap and focused funds from calendar year 2018 points out that the relative performance of the latter has not been impressive. “Going by historical data, I have not really seen that big alpha stand out for the focus funds—barring a handful of schemes—for the higher risk it takes,” said Nitin Raheja, executive director, head-discretionary equities, Julius Baer.

As the performance of concentrated portfolios is dependent on fewer stocks, the risk that comes with focused or PMS funds is typically higher than that of a diversified flexi cap fund. But the category average returns do not indicate a commensurate reward by focused funds for the higher concentration risks.

This is not to say returns from all focused funds were poor or all flexi-cap funds outperformed. Of the 20 focused funds with at least a three-year track record, four funds—IIFL Focused equity, SBI Focused Equity, Quant and Sundaram Focused —have been top performers, on a rolling return (3-year) basis over the last one year. The table highlights the strategy of these funds.

Focused vs PMS

The biggest advantage with focused funds compared to PMS is its taxation. PMS investors need to account for capital gains on every sell transaction by the fund and is also subject to advance tax payments and reporting, which is applicable to mutual funds only at the time of redemption of the fund. But PMSes have a few benefits.

Unlike focused funds, PMSes are not liable for any investment restrictions that Sebi has for mutual funds. For example, to ensure diversification and reduce concentration risk, Sebi mandated that in the case of equity funds, a scheme’s portfolio cannot hold more than 10% in a particular stock.

Despite fewer investment restrictions on PMSes, the category average returns from them have not been higher meaningfully (see table).

Feroze Azeez, deputy chief executive officer at Anand Rathi Wealth, said that on a rolling return basis, the top 5 focused funds have beaten the top 5 PMS funds (based on AUM) in both short and long periods of 1-year, 3-year and 5-year. There is also a wide divergence in the returns of best and worst-performing PMSes. For example, the 3-year return of a best-performing PMS is 33%, the worst is 1%, with the average at 15%.

Thus, selecting the right fund manager becomes a crucial aspect while investing in PMS. On the other hand, focused funds in India have a narrow performance range. This is on account of their exposure to the large-cap segment along with similar allocation to multiple sectors (such as banks, Information Technology, etc.,) by various funds in the category.

Where to invest

Experts believe that individuals who just started their investing journey can stick to diversified flexi cap funds since the risk with focused funds is higher. “Once you have a larger portfolio and are willing to slightly increase the higher risk, you can consider focused funds. Also, I think it should be part of the tactical allocation and not core allocation,” said Saurav Basu, head of wealth management, Tata Capital Ltd.

If you are confused about investing in a focused fund or a PMS, check out the proportion of investment in concentrated portfolios, according to Vishal Chandiramani, chief operating officer at TrustPlutus.

“For someone with, say, 2 crore investment, an investment of 50 lakh in PMS implies 25% of their portfolio is invested in an extremely high concentration fund. He/she would be better off investing 20 lakh in focus funds, which would make up 10% of the portfolio,” he added.

When choosing a PMS fund manager, in addition to aspects such as the fund managers’ investment style and their investment philosophy, fees is a big factor, said Prateek Pant, chief business officer, WhiteOak Capital AMC . “Typically, the fund manager’s fee must be anywhere between 1.5% and 2.5%,” he added.

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