In India, SEBI sets specific rules for different types of equity mutual funds to regulate them. For example, in large-cap funds, managers must invest at least 80% of the fund’s assets in large-cap stocks, and multi-cap fund managers are required to allocate at least 25% of their assets each to large, mid, and small-cap companies.
In a similar manner, focused mutual funds are governed by specific rules. SEBI allows these funds to invest in a maximum of 30 stocks but gives fund managers the freedom to choose stocks from any market cap. This concentration of stocks lowers the fund’s diversity but also raises its potential for delivering returns. Here, we’ll discuss what focused funds are, how they work, and who should consider investing in them.
What is a Focused Equity Mutual Fund?
According to the Securities and Exchange Board of India, a focused fund is a type of equity oriented mutual fund that can invest in no more than 30 stocks. The manager must allocate at least 65% of the fund’s total assets to equities, but they are allowed the flexibility to choose stocks across large, mid, or small-cap based on their growth potential.
Generally, equity funds hold anywhere between 50 to 100 stocks in their portfolios. This offers diversification, which is a key selling point for mutual funds. However, since focused funds invest in only 30 stocks, the benefit of diversification is diluted.
These stocks are very carefully selected and bet big on stocks that the fund managers think will do well in 4 to 5 years. Diversification also dilutes returns, so the idea behind ‘under diversified’ focused funds is to generate higher returns by investing significantly in fewer companies. Naturally, this concentrated strategy also brings higher risk, as the fund’s performance heavily depends on the success of those limited investments.
Now that you know what is focused equity fund, let’s understand how it works.
How Does a Focused Equity Fund Work?
Focused funds take concentrated bets on a few select stocks. These funds are targeted at investors who feel that while diversification reduces risks, it can also dilute returns. Thus the objective of focused funds is to maximise gains by investing heavily in high-potential stocks which can grow significantly in the next 4 or 5 years.
The key differentiating factor between focused funds and other equity-focused mutual funds is the number of stocks they are allowed to invest in. Equity funds like multi-cap funds invest in well over 50 stocks, whereas focused funds are limited to only 30. Focused funds do share some similarities with other equity funds, like needing to invest at least 65% of their assets in equity or equity-related securities.
Other than the 30 stocks only factor, a focused fund works similar to how a flexi-cap fund operates. There are no restrictions on which market cap to invest in, so fund managers can choose freely from large-cap, mid-cap, or small-cap stocks.
Advantages of Focused Equity Mutual Funds
Potentially higher returns – Since focused funds aren’t as diversified, they have the potential to generate higher returns compared to other equity category funds. This is especially apparent in polarised market conditions, where only specific sectors or stocks outperform the rest. In these scenarios, the targeted strategy of focused funds can generate significantly higher returns.
Better stock selection – When fund managers have to manage a limited portfolio of only 30 stocks, they can dedicate more time and resources to thoroughly analyse each investment. They conduct in-depth research and target high-quality companies with strong fundamentals and growth potential.
Flexibility across different market caps – Unlike multi-cap funds, focused funds have the freedom to allocate their assets to any company regardless of market capitalisation. This has two advantages. While focused funds are not as diversified in terms of the number of stocks, their ability to invest across market caps provides a different form of diversification to investors. Secondly, it allows fund managers to adapt to market conditions and invest where they see the most value, regardless of company size.
Risks and Disadvantages of Focused Funds
Like any other equity mutual fund, focused funds are subject to market risk. They are associated with higher volatility due to the concentrated portfolios they maintain. Holding only 30 stocks means that each stock carries more weight in the overall performance of the fund. As a result, the fund’s returns depend more on the performance of a few stocks. If they underperform, the entire fund can experience significant losses. So while the portfolio concentration increases the ceiling for returns, it also invites more risk.
Who Should Invest in Focused Equity Funds?
As mentioned before, some individuals who invest in focused funds believe that diversification across 50 to 100 stocks can dilute the returns generated by funds like large-cap or multi-cap funds. A carefully selected portfolio of 30 stocks has a higher potential for generating returns but also comes with high risk levels. If you’re someone who is considering investing in a focused fund, note that:
1. Focused funds can be risky
As they only invest in a maximum of 30 stocks, focused funds are considered to be under diversified, and thus the associated risk is much higher. Investors with a high risk appetite who understand that the potential for higher returns comes with a bigger chance of volatility can consider investing in these funds.
2. Focused funds are suitable for experienced investors
Due to the concentrated nature of their portfolios, focused funds are suited for investors who have a solid grasp of how the stock market works. Experienced investors can fully understand the risks these types of funds carry and are better equipped with the knowledge to make the right decisions. These funds tend to see a lot of short-term volatility which can be intimidating for new investors, as they might not be able to tolerate the fluctuations.
3. Focused funds have at least a 4 to 5 year investment horizon
Since these funds deal with equity, investors must give them time to overcome short-term fluctuations and grow. Around a 5 year time frame can be enough for the stocks to realise their growth potential and for the fund manager’s selected picks to generate returns. Therefore, investors who can commit their money for the long term are better suited for investing in focused funds.
Equally important are the investor’s financial goals. After defining your goals, it’s important to assess whether focused funds are truly the most suitable vehicle for helping you realise them. Focused funds can be an excellent option for those wanting to earn higher returns but they do not suit everyone’s risk tolerance or financial situation. To make a well-rounded decision, you should consider consulting a financial advisor.
A qualified professional can understand your risk appetite, financial goals, and investment horizon, and give personalized advice to help you choose the most suitable investment vehicles for your unique circumstances.
Performance Metrics of Focused Equity Mutual Funds
Here are some more factors investors should evaluate before investing in focused funds:
1. Fund’s past returns and consistency
One of the first things that investors evaluate is a fund’s past returns. It’s important, however, to look beyond just returns and focus on the fund’s consistency. A consistent performance over 3, 5, or 7 years is important for evaluating the fund’s ability to deliver sustained results. There are some conditions where focused funds present the opportunity for relatively high returns. In polarised conditions, for example, focused funds can outperform other diversified equity funds as only a few stocks drive the overall market growth. The fund manager can quickly shift to these stocks and reap rewards.
2. Risk-adjusted returns
These metrics are used to gauge whether or not the returns of an investment are worth the risk taken to earn them. For example, a fund with better risk-adjusted returns suggests that it delivers higher returns for every unit of risk it takes. Ratios like the Sharpe, Treynor, and Sortino ratios must be considered before making any decisions.
3. Fund manager’s track record
Given the concentrated nature of the portfolio, the performance of a focused fund is highly dependent on the decisions made by the fund manager. That’s why understanding how well the fund manager has done in the past is so important when considering an investment in a focused fund. The success of the fund heavily depends on the manager’s ability to pick the right stocks that perform well over time.
4. Expense ratio
The expense ratio is the annual fee charged by the fund house to manage investments and covers expenses such as management fees, administrative costs, and marketing expenses. A lower expense ratio can help investors gain more returns, so it can be a good idea to compare these costs across different funds.
5. Taxation
Since focused funds mainly invest in stocks, they are taxed like any other equity-oriented mutual fund. A short-term capital gains tax is levied when investors sell their focused fund’s units after holding them for less than 12 months. The STCG tax is charged at a rate of 20%. On the other hand, profits made when selling the investment after 12 months are considered long-term capital gains and taxed at a rate of 12.5% (A tax exemption of Rs. 1.25 lakh is applicable in the case of LTCG)
Conclusion
Focused Mutual Funds are a type of equity mutual fund, which according to SEBI, can invest only in 30 stocks. The regulations allow some flexibility to these funds in that they are permitted to invest in any stock across any large, mid, or small market caps. The concentrated portfolio reduces the benefit of diversification but at the same time, it also offers investors the potential to earn higher returns.
Before investing, investors should analyse their financial goals, risk tolerance, and investment horizons as focused funds do not suit every investor. They should only be considered by experienced investors who have a long-term horizon and understand the risks associated with concentrated portfolios. Other than these, investors should also assess metrics like the fund’s history and consistency of returns, the fund manager’s skill and experience, risk-adjusted returns, the fund’s holdings, and expense ratios before investing.
