Focused Funds: A Methodical Approach To Stock Selection

The Indian equity markets have been trading on shaky ground since the start of 2022. With global markets also feeling the heat of rising inflation, mutual funds have become an apt investment avenue in the medium to long term. The article takes a look at what focused funds have to offer. 

The basic idea of investing is to diversify your portfolio rather than putting all your eggs in one basket. While it is critical to distribute investment over a variety of stocks and sectors to minimise the overall portfolio risk, simply increasing the number of stocks in an equity portfolio reduces the performance beyond a certain point. In fact, a portfolio with far too many stocks and lesser proportion may dilute the benefits of performing stocks.

Composition of Focused Funds Focused funds, as the name implies, invest solely in highquality stocks with the potential to generate wealth in the long term. The goal of this fund and fund manager is to build a successful portfolio by limiting investments to high conviction stocks with optimal risk-to-reward ratios. A focused fund can invest in a maximum of 30 stocks with a minimum of 65 per cent of the portfolio in equity and equity-related securities, according to the mandate issued by the Securities and Exchange Board of India (SEBI). Focused funds can invest in a wide range of market capitalisations, including large, Mid-Cap and small-cap companies.

While conventional equity funds do not have a limit on the maximum number of stocks they may invest in, focused funds concentrate and keep their basket to 30 stocks. According to studies, once a portfolio is diversified over 20-25 stocks, unsystematic risk as measured by standard deviation reaches ideal levels. A focused fund is the only mutual fund with such restrictions, while other mutual funds are allowed to invest in up to 100 stocks. 

Deep Dive into Focused Funds
With the responsibility to manage a concentrated portfolio, the fund manager of a focused fund strives to select only highquality companies discovered after thorough research, with a clear focus on risk management, following the scheme’s investment strategy. The goal of these funds is to attain high growth by investing in a small number of quality companies with high growth potential. In the last 10 years, focused funds have outperformed Large-Cap and multi-cap funds, while in the same period they have generated a CAGR of 18.2 per cent, which is greater than the 15.6 per cent and 17.8 per cent CAGR delivered by large-cap and multi-cap funds, respectively. However, you need to bear some points before investing in focused funds.

✓ As each mutual fund has its own set of terms and conditions, focused funds must follow them as well.

✓ Implications for Taxes : Focused funds are taxed as equity funds since they are equity-oriented. Long-term capital gains (LTCG) are taxed at 10 per cent on gains above `1 lakh in a calendar year. Short-term capital gains (STCG) are taxed at 15 per cent if the money is taken out before a year has passed.

✓ Fund Manager’s Expertise : The fund manager’s abilities and knowledge are critical to the success of a focused mutual fund investment. To assure strong returns, he or she must conduct thorough research and use an expert screening procedure to select the best-performing companies. Working with the fund management to find the fund’s top holdings, filters and knowing the history of the funds can also be beneficial.

✓ Economic Goals : Those looking to invest for a short period may not benefit from investing in a focused fund. That is because in order to maximise returns, the investment must be made for 5-7 years. Another consideration is whether to invest in mid-cap or large-cap funds, which should be determined by your investing goals.

Risks to Consider
The limit on the number of stocks that can be invested is likewise fraught with danger. If you have a high risk tolerance, you should invest in this concentrated pool of stocks in the event of a market downturn. Investors should be aware that a concentrated approach may expose them to a higher level of investment risk as the selected bets may not perform as planned. With fewer equities in the portfolio, the chances of other portfolio assets compensating for one segment’s underperformance may be reduced. As a result, investors with a higher risk appetite may want to explore such funds.

Advantages of Focused
Fund Investors might benefit from a more concentrated approach to stock selection by investing in focused funds. It lowers the danger of over-diversification in a portfolio. When a fund invests in a large number of equities, not all of the securities may perform at the same time. While a fund manager in another category may choose to limit the number of portfolio stocks, this fund does so as a matter of investment philosophy. Tracking the investment portfolio becomes considerably easier when the number of stocks in it is reduced. Furthermore, the stocks are chosen after thorough research and analysis to reduce the number of stocks in the portfolio. As a result, fund managers pay close attention to the stocks’ growth prospects in order to provide better returns to investors.

Target Investors
The question is who should invest in focused funds? Here are some pointers:

✓ High Risk Tolerance : Because of the limited number of stocks in their portfolio, focus funds carry a higher risk. The fund manager invests in stocks that he or she believes will yield the investor significant returns. However, because of this concentration, even one bad company can result in significant losses. As a result, individuals who are willing to take a bigger risk should have a look at focused funds.

✓ Prior Experience : If you are new to investing, this fund may not be the best place to start. This is because in the short to medium term it can be more volatile. So, if you have a few years of investment expertise, go with them, but be aware of the hazards involved.

✓ Time Horizon : As these are equity funds, you should give them at least five years to demonstrate their actual potential. Moreover, these funds make selected bets, and those bets may take time to pay out. Only those who can commit to investing for the specified period of time should do so.

Conclusion
Are focused funds a good investment avenue? In polarised markets, focus funds can outperform diversified funds and even the broader markets. A polarised market is one in which a small number of stocks propel the market ahead while the bulk of listed stocks remains stagnant. If the stocks chosen by the focus fund are included in that select list, you will see a significant increase in returns. On the other hand, if the market surge is more widespread, you may not get the rewards that justify the risk you are taking. On account of the possibility of large returns and limited stock options, it may be appealing to invest in focused mutual funds. However, there are several other variables to consider before making the investment. Make sure you pick the right fund for your risk profile and financial vision. Before making the selection, read and understand all of the risks connected with the investment.