Why wealth managers are taking smart positions in this category to brace for volatile times ahead

Expectations of the US Federal Reserve raising interest rates faster than expected, followed by geopolitical tensions over Ukraine and Russia, have sparked volatility in equity markets after an almost two-year rally.

Experts say the easy money is behind us and it’s time to pick the right stocks to make money. Does that make a case for focused funds?

A broad market rally may be a thing of the past

Focused funds are equity funds that invest in a portfolio comprising a maximum 30 stocks. Some funds restrict the stocks in their portfolio to an even fewer number.

According to ACE MF data, over the five-year period to March 6, 2022, focused funds have delivered an average annual return of 12.45 percent compared to 12.9 percent given by flexi-cap funds. Although focused funds are restricted from investing in more than 30 stocks, there is no limit on the size of the company in which they can invest unless a fund itself opts for a cap.

Flexi-cap funds do not have any such restrictions. Over the last one year, flexi-cap funds, with a 11 percent return, have outperformed focused funds that offered a 9.02 percent return. The latter may stage a comeback.

A rally fuelled by abundant liquidity may not continue, but not all stocks go down from here. Even so, investors may back only fundamentally strong stocks going forward.

“Over the last couple of years there have been significant changes in cost structures of businesses,” said Manish Kothari, co-founder and CEO of ZFunds, a mutual fund platform. “Cost of capital is also going up with expectation of rising interest rates, and investors’ risk perception towards business is also changing. This should pave way for the stock-specific movements going forward compared to the broad-based rally in stocks in the last two years.”

Deepak Chhabria, founder and managing director of Axiom Financial Service, too, does not expect the broad- based rally to continue.

“Stock-specific movements may become the order of the day, offering scope for active fund managers to outperform. Investors may pay more attention to valuations and value investing may gather further momentum,” he said.

That’s making many investors contemplate investing in the best ideas of their fund managers. Here is where focused funds are coming in.

“Focused funds should ideally generate significant alpha over the benchmark for fund managers with stock-picking skills as the stocks picked get a higher allocation compared to other diversified funds,” said Shridatta Bhandwaldar, head-equity, Canara Robeco Mutual Fund.

Canara Robeco, UTI, HSBC, Invesco India and Mahindra Manulife Mutual Fund have launched focused schemes in last two years.

Focused versus flexicap

Although focused funds are presented as a bouquet of high-conviction ideas of the fund managers, some are not enthused about recommending them to investors.

“Focused funds expose investors to concentration risk and looking at past performance, most of them do not compensate investors with excess returns when compared to other diversified offerings like flexi-cap funds,” said Srikanth Bhagavat, managing director and principal advisor, Hexagon Capital Advisors.

Focused funds can invest as much as 9 to 10 percent of their money in a stock; in the case of a flexi-cap fund, the typical portion may be around 5 to 6 percent. Sure, positive developments related to a stock in their portfolio can present a large upside. Equally, negative developments mean large losses.

“Given the cap on the number of stocks, as the size of focused funds increases, it becomes difficult to allocate money to mid- and small-cap stocks... money goes into large-cap stocks,” said Kothari.

He sees flexi-cap funds as being better placed to take advantage of compelling money-making ideas in the small- and mid-cap space.

“The entry and exit from stocks can be relatively easy for a flexi-cap fund given a long tail of stocks, compared to a focused fund,” he said.

According to ACE MF data, as of January 2022, focused schemes had on an average allocated 71 percent of their money to large-cap stocks.

What should you do?

Focused funds may work for those who are looking for high-conviction ideas. Yet, Bhagavat does not think that it is necessary to invest in focused funds.

“If you are keen on a focused portfolio, then allocate some money to a scheme with a good track record as a part of satellite allocation. Most likely, you get to see accentuated outcomes both on the upside as well as on the downside,” he said.

Among a curated list of schemes in MC30, Axis Focused 25 Fund and SBI Focused Equity Fund make the cut, which can be used as a satellite holding in your portfolio.

Even if you are investing in a focused fund, do not a expect consistent outperformance to the benchmark on a quarter-on-quarter basis.

“Fund managers of focused funds, typically, veer away from the benchmark. Performance is more active here. Investors hence need to look at the long-term performance of focused investment strategy and not read too much into the short-term,” said Bhandwaldar.

Testing your conviction

Focused funds thus test the conviction of investors too, by testing their patience through tough times in the market.

“If you are really keen on a concentrated portfolio, then go long on the oldest concentrated portfolio in India with the longest track record – BSE Sensex Index,” said a financial services professional whose company policy does not allow him to speak to the media.

The Sensex houses 30 stocks and has offered a 14.47 percent annual average return over the last 20 years.

Kothari is of the opinion that focused funds do not add value and most investors are better off allocating money to flexi-cap funds. Flexi-cap funds can work for investors seeking alpha excess over market returns.

“One need not necessarily go to focused funds for outperformance arising out of a fund manager’s conviction. At times, a flexi-cap fund manager can also take large exposure to stocks in a particular theme or sector and deliver superior returns compared to benchmark indices,” said Chhabria.