Concentrated Fund vs Diversified Fund
Concentrated Fund vs Diversified Fund Concentrated or diversified mutual fund, which one should you go for. DSIJ analyses the pros and cons of investing in the concentrated and diversified equity mutual fund.
Indian mutual fund industry is in a high acceleration mode since last couple of years. Investors are rushing to invest in the mutual funds due to its attractive returns and flexibility. Investors are usually advised to have a diversified portfolio of funds to reduce the risks. However, if we take note of the thoughts of the investment gurus such as Warren Buffet, Philip Fisher, we find that these gurus have suggested investors to invest in a concentrated manner to reap more returns. So, retail investors are always faced with the dilemma: whether to have a concentrated or a diversified portfolio? The article deals with this dilemma and aims to clarify the ideal way to reap more returns with proper risk exposure. But first let's understand what are diversified and concentrated mutual funds and how they work.
Diversified Fund- These funds invests across various market caps and sectors to reduce the risk exposure. These schemes hold around 40-70 stocks in the basket, out of which top 10 stocks form around 40% of the corpus. In these funds, the sectoral weightage is also well-distributed to avoid any concentration to reduce the risk. Owing to this diversification strategy, these funds are considered as safer in terms of volatility.
Concentrated Funds- The concentrated funds are funds that invest in the limited number of stocks instead of investing across a diversified mix. This type of fund generally holds 20-30 stocks in the basket, where the top 5 stocks form around 50% or more of the corpus. This means that it takes more exposure to the stocks which the fund manager may consider as the best picks.
The concentrated funds or focused funds are identical to other mutual fund schemes. These are just different in the case of their holdings. These funds hold lower or limited number of stocks with a strategy to avoid oversizing of the funds. These schemes concentrate on the fund manager's best picks and take higher exposure in those stocks, with the intention of generating higher alpha.
However, these funds cannot invest more than 10% of their portfolio in a single stock. The investment can go up to 12% in a single stock only after the approval of the trustees. The most important aspect of the concentrated portfolio is the fund manager's skills. If the fund manager is able to pick the best, the investor will reap higher returns and vice-versa. With the lower number of stocks, the underperformance of other stocks can be compensated by the higher performing stocks. So it seems to be a high risk affair for the investor, but the risk exposure will be a benefit for him in the shorter run in terms of returns.
On the other hand, a diversified scheme follows an investment approach of investing in around 40-70 stocks with a limited and calculated exposure. Owing to this, diversified funds typically have lower volatility. But on the flipside, many a time, the performance gets impacted due to the diversification. This happens when the outperformance of the top performers of the scheme is dragged by the underperformance of some of the stocks in the portfolio, due to which the alpha of the fund gets diluted over a period of the time.
We have analysed some of the concentrated as well as diversified mutual funds to analyse their return patterns. In the analysis, we have observed that in the case of returns, concentrated funds reap more returns in the shorter run, whereas in the longer term, diversified funds nearly equal the returns of concentrated funds. The trend of the short-term and long-term returns can be observed in the table below.
Even if the concentrated fund shows higher returns one should be aware of the risks associated with it while investing into the same. A concentrated portfolio can be hit badly if the fund manager's calls go wrong. The ratios of these funds also appears high due to fewer number of stocks, so that a small mistake in selecting a stock for the basket by fund manager can cost high for the investors. Therefore while selecting the focussed fund the abilities of fund manager and track record also become an important aspect.
Considering all these aspects, it is very clear that concentrated mutual funds are an return accretive investment avenues where risks are higher, so these are most suitable for investors having sound knowledge of the sectors and have a high risk appetite to reap higher returns in the shorter term. However, for the new investor or risk-averse investors, the diversified funds are a good option for the longer run as these funds perform well with lower volatility in the longer run. .
