Focused Funds

The SEBI (Mutual Funds Regulations), 1996 has mandated focused funds to invest in a maximum of 30 stocks to stay true to their investment philosophy.

This contrasts with most equity categories, where schemes typically invest in 40+ stocks.

While focused funds don’t have market cap restrictions, they must mention if they intend to focus on a particular market cap. It could be one of large cap, mid cap, small cap or the multi-cap investment approach could be adopted.

For example: Mirae Asset Focused Fund has a multi-cap investment approach, whereas Aditya Birla Sun Life Focused Fund has a large-cap focus.

You can find the focus/approach of focused funds in their respective Scheme Information Documents (SIDs).

This makes focused funds similar to flexi cap funds that invest in any stock across market cap, sector, and style without restrictions.

The only significant difference between focused and flexi-cap funds is that flexi-cap funds tend to be much more diversified (50+ stocks) than focused funds (20-30 stocks).

In contrast, most other equity funds have clear restrictions in terms of either the size of the company whose stocks they can invest in (for example - mid-cap funds) or the sector that the company belongs to (for example - sectoral funds) or investing style (for example - value funds).

Focused funds have 3 significant benefits:

1. Potential for higher returns than diversified funds
2. More flexible than fund categories with restrictions
3. Better tax treatment than Portfolio Management Services

Potential for higher returns than diversified funds

Investing in a few but the right stocks can result in higher returns than investing in a portfolio with many stocks. However, it is just potential and may not necessarily materialise. 

More flexible than fund categories with restrictions

Large-cap funds need to invest in large-cap stocks. Value funds need to invest in value stocks. Sectoral/thematic funds can only invest in one sector/theme stocks.

But focused funds have no such restrictions. 

They can invest across market caps, sectors, and investment styles if the scheme information document specifies This gives flexibility and freedom to the fund management team to find opportunities wherever available. 

Further, the flexibility helps navigate challenging market conditions by increasing allocation to large-cap stocks/defensive sector stocks that are less affected than other stocks.

Better tax treatment than Portfolio Management Services

Portfolio Management Services (PMS) are customised investment solutions offered by SEBI-registered portfolio managers. The minimum investment required to invest in a PMS strategy is Rs. 50 lakh.

But why are we discussing PMS?

Well, because Portfolio Management Services, more often than not, follow the focused investment strategy. As per PMS Bazaar’s research, the average number of stocks in a PMS strategy is 25.

This means portfolio managers also generally have a focused investment approach. But instead of focused funds, which can invest in a maximum of 30 stocks, PMS strategies mostly run concentrated portfolios to chase high returns.

But here’s the interesting part: when the fund manager of a focused fund sells a stock at a profit, neither the mutual fund nor you are taxed. This is because mutual funds don’t have to pay taxes, and gains are taxed only in your (investor’s) hands.

In contrast, when you invest in a PMS, you own the stocks directly. So, you will be taxed whenever the portfolio manager sells stocks in your portfolio at a profit.

So, from the tax perspective, focused funds are better placed than comparable Portfolio Management Services.

You can read this article by Live Mint that compares focused funds with PMS across other factors like performance and risk too.

Focused funds have a couple of structural problems. Here are two of the biggest problems with focused funds:

1. Higher volatility than diversified funds
2. Disproportionate dependence on fund management

Higher volatility than diversified funds

It is well established that as you add more stocks to a portfolio, the portfolio becomes more and more stable.

On the other hand, as you reduce the number of stocks in a portfolio, it becomes more and more volatile.

A focused portfolio with a maximum of 30 stocks will always tend to be more volatile than a diversified portfolio with considerably more stocks.

Disproportionate dependence on fund management

A Flexi cap fund, if it wants to take exposure to a sector, say FMCG, can invest in as many FMCG stocks as it wants. By doing this, it manages the risk of 1 or 2 stocks not performing for company-specific issues despite the FMCG sector performing as expected by the fund manager.

In contrast, a focused fund can invest in the FMCG sector through a very limited number of stocks because of the 30-stock restriction at the scheme level. The selected FMCG sector stocks may perform very severely due to company-specific issues despite the FMCG sector performing exceptionally well.

Similar incidents can occur across sectors, market caps, and investment styles. Hence, the fund manager/management team’s decision-making must be precise. If not, it is possible that their investment bets may not work out despite good performance by the underlying sectors/market caps/investment styles.

Focused funds have their merits and demerits. While it is difficult to say whether you should invest in a focused fund, here are some use cases we think focused funds fit in:

Professional investors

If you are a professional investor or someone who manages their own money, focused funds should be on your radar.

If your portfolio has a solid base of large-cap active/index funds and you are exploring funds with higher return potential, focused funds could be your answer. But you should always remember that higher return potential comes at the cost of higher risk.

Simplify your portfolio

If you have too many funds across categories in your portfolio, flexi cap, and focused funds can make your life easy.

It is recommended to have at most 8-10 mutual fund schemes in your portfolio. 

If you have too many across different categories, replacing them with a couple of flexi cap/focused funds to invest in opportunities across the market may make sense.

Invest with your favourite fund manager

If you like a fund manager or are impressed by their track record, investing in a focused fund they manage may work out very well.

We saw that focused funds have no restrictions in exploring or investing in market opportunities irrespective of market cap, sector, and style. Further, focused funds make concentrated bets in about a couple of dozen stocks. These two factors are conducive for a good fund manager to shine and deliver high returns.

Could be better than PMS strategies

As we saw earlier, focused funds and Portfolio Management Service strategies are similar because they look for opportunities across the market and have concentrated investment portfolios.

Focused funds are better than PMS strategies on three fronts:

1. More tax efficient
2. Better risk management
3. Low investment requirement

For these three reasons, you can consider focused funds for investing if you are already considering Portfolio Management Services.

If you are not an expert investor and want to explore focused funds for your portfolio, it is best to talk to an investment advisor. 

Before investing in focused funds, please consider your financial situation, goals, and risk tolerance. Please don’t rely solely on the content of this article to consider or invest in them.

Disclaimer: Mutual fund investments are subject to market risks, read all scheme related documents carefully. Readers are requested to consult their financial advisors before investing