Focused Equity Funds: Where Small Can Indeed Be Beautiful

Diversification is an essential element of portfolio construction, beyond a point, diversification does not add much value to the portfolio.

To start with, let us look at the concept of focused equity funds. In the regular fund categories like largecap or multicap, there is no restriction on the number of stocks in the portfolio. In some cases, there is a restriction on the universe of the underlying e.g. 100 stocks to choose from in largecap or 150 in midcaps. In other categories e.g. ELSS, it is an open field for the fund manager. On Friday, Sebi clamped similar restrictions on multicap funds, which is enforceable by January 31. 2021.

And then, there is the focused fund category defined by Sebi as “a scheme focused on the number of stocks (maximum 30)” and “mention where the scheme intends to focus, viz., multicap, largecap, midcap, smallcap.”

The benefit of following such a strategy is that a lot of gains can be made if the high conviction stock ideas are proven right, but then the portfolio can lose as much if the stock ideas don’t deliver.

What does this tell us? In regular fund categories, there is flexibility to the fund manager with the art /science of fund management. In focused fund, it is about taking concentrated bets on stocks where the fund manager has a high degree of conviction. That being the case, there being a defined limit of 30 stocks, it makes the context of diversification relevant.

While diversification is an essential element of portfolio construction, beyond a point, diversification does not add much value to the portfolio.

You take your pick, but Warren Buffet said ‘wide diversification is only required when investors do not understand what they are doing’. What is ‘wide’ in this context is debatable, but the point is, after the optimum extent of diversification, the incremental value is not as much. In other words, if one were to diversify too much, you may not lose much, but then you won’t gain much either.

Now let us look at the performance of the category of focused funds. For benchmarking purposes, we have taken the multicap category, where there was no restriction on stock selection or portfolio construction till now. Over the past five years till August 27, 2020, a basket of 12 leading multicap funds have given annualised returns of 8.1 per cent. Over the same period, a basket of 12 leading focused funds have yielded 9.1 per cent annualized. The outperformance shows that the legal restriction of 30 stocks in the portfolio is not really a restriction in the broader sense.

Investors willing to go with the stock picking abilities of the fund manager/AMC can allocate a portion of the equity component of the portfolio to focused funds.

Having understood the proposition for focused funds, the question now arises, how to pick the right fund? It is important to choose the best focused schemes, as returns can be volatile, and therefore, such schemes come with a higher risk than diversified equity funds, but lower risk than sectoral/thematic funds, where the universe is limited. It is well known that we should look at long period performance to gauge fund managers.

Additionally, in focused funds, we should look at (a) performance across market cycles because it is about concentrated bets and (b) fund sizes, where bigger is not necessarily better, as there is a limitation on the number of stocks. Over a period of five years till August 27, 2020, the best performer in the focused category is Axis Focused 25, which has delivered 12.86 per cent annualized. However, the fund return for the latest six months has been a negative (-) 3.69 per cent and for latest nine months, it is negative (-) 1.02 per cent. For perspective, the latest six-month return from Nifty50 TRI till August 27 2020 is 0.12 per cent, Nifty500 TRI is 0.72 per cent. The nine-month returns from Nifty50 TRI till August 27 2020 is (-) 3.7 per cent and that of Nifty 500 TRI is (-) 1.62 per cent.

The point is, sometimes, concentrated bets get tested in difficult market conditions. The second-best performer over five years is SBI Focused Equity Fund with 11.98 per cent annualized returns. Over the last six months, it has given -4.01 per cent and over past nine months, 0.51 per cent. ICICI Prudential Focused Equity Fund has given 9.15 per cent annualized over 5 years, and outperformed with 14.05 per cent over last six months and 9.17 per cent over nine months. This fund has given the highest year-to-date return of 9.73 per cent till August 27, 2020 in this category.

The data discussed above throws up the topic mentioned earlier: smaller the size the better it is in the focused category, as this gives more flexibility to the fund manager in stock picking. The corpus size of Axis Focused 25 is more than Rs 9,000 crore and that of SBI Focused Equity Fund is approximately Rs 8,000 crore. The third biggest fund in this category, Franklin India Focused Equity Fund with Rs 6,700 crore has given a year-to-date return of (-) 8.5 per cent. The fund size of the best performer, ICICI Focused Equity Fund, in comparison is less than Rs 600 crore.

To conclude, investors should allocate to focused funds of fund houses where fund managers show conviction in his bets. The parameters for selecting such funds should be past track record, performance over long term and through market cycles and corpus size, where relatively smaller appears to be better for the sake of flexibility. One should enter such funds in a staggered manner through SIPs or STPs instead of trying to time the market.


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