The Mutual Fund Show: Why Focused Funds Can Be A Good Investment Option
It may be confusing for investors to choose a right portfolio, especially in times of crisis like the Covid-19 pandemic, from a mix of debt and equity options available. But mutual fund advisers have an idea.
Focused funds invest in limited securities in select sectors rather than a diversified mix of equity. A fund manager can choose up to 30 stocks in such schemes instead of holding a combination of 50-60 stocks or more. The schemes, according to the market regulator’s norms, should mention where it intends to invest, for instance, large cap, multi cap, etc.
Focused funds have gained traction over the last couple of years. The rally in the benchmark indices, led by a few heavyweights (prior to the Covid-19 impact), aided the returns for these schemes that had higher exposure to such stocks, said Gurmeet Chadha, chief executive officer and co-founder at Complete Circle Consultants Pvt. The unsystematic risk in investing doesn’t significantly reduce from diversification beyond 30 stocks, Chadha said on BloombergQuint’s special series The Mutual Fund Show.
Focused equity funds have outperformed large-cap peers in the last five years. The category average returns for focused funds stood at 6.2% compared with 5.5% for large caps, according to data from Morningstar India.
While a concentrated portfolio (top 10 stocks typically account for 60-70% of the portfolio) increases the odds of an outsized positive impact on the fund, the lack of diversification enhances the impact of a loss-making investment and higher volatility, said Amit Bivalkar, director at Sapient Wealth Advisors & Brokers Pvt. “For people who understand concentration risks, I think you should go for focused funds.”
Watch the full video here:
Here are the edited excerpts from the interview:
Gurmeet, are you telling a large portion of your clients who didn’t want to invest in equity funds to go for the multi-cap route or are you suggesting otherwise? Why or why not?
Chadha: So, we prefer multi-cap as a category over trying to be too tactical with your small-cap bets or thematic bets. We largely prefer with a staggered route right now when markets have run up. Within multi-cap, you have your multi-cap and then you have large and mid-cap as a category. There is a focused category which broadly is multi-cap, but some of the large-cap funds are also being run. This actually was pioneered by Motilal Oswal when it launched the Focused 25, Focused 35 funds.
Right now, why we are more looking at focused funds is that the market has been polarised with a handful of stocks doing well across geographies, not just India. We’ve seen that with the Nasdaq, we have seen that with most indices. Second, what we’ve studied is that the unsystematic risk, which is what diversification seems to cater to, after 30 stocks, the more stocks you add incrementally doesn’t really make a difference in terms of reducing your unsystematic risk. Third, with a concentration in the market, the market being polarised, your stock picking and a concentrated portfolio tends to do better. So for example, RIL is 14% on the index, now a mutual fund technically can’t have more than 10% in a single scrip. Similarly, if you have a multi-cap fund, which is let’s say 15,000-20,000 crore, you want to buy some mid cap or small cap. Let’s say you want to add a company which is Rs 10,000-crore market cap, how much will you be able to buy? So a 20,000-crore fund to have a 5% exposure, you have to buy 1,000 crore of a particular scrip. So, that won’t move the needle much. It gives you a bit of flexibility, gives you a bit of fungibility but yes, it can work both ways.
The focused category is a concentrated portfolio. Typically, the top 10 stocks are about 60% of the portfolio versus average multi-cap funds where the top 10 stocks will account for 40-45%.
Amit? Is multi-cap the way to go or is your thought different?
Bivalkar: So I think the categorisation happened through SEBI white paper, what you could actually get from the focused categorisation was that you can have maximum 30 stocks in a focused fund but you have to actually give a focus — whether your focus in that fund will be large-cap, mid-cap or small-cap. So when you’re trying to invest in a focused fund, the fund house has to give out a declaration saying that whether that fund is going to focus on large, mid or small. If you try to look at any of the focused funds, they are not actually heavy on the small-cap portion. Just to name, you have got some funds which range between 60 and 80% in large-cap, some which are 20-30% mid-cap, some are between 5 and 25% small-cap. So, before entering any focused fund, I think it is more important to see what is the focus of that scheme and that is written on their site.
The second thing is, I agree with Gurmeet that more the concentration, more the gains on the portfolio, because your top 10 will be 60-70% of the portfolio. But I would look at focused fund as more that people cannot invest in PMS now below Rs 50 lakh. So, if you want to look at a 30-stock portfolio with concentrated bets, which can go across market cycles but the focus is clear on, I think you need to have that clear and then enter into focused funds. At Sapient Wealth, we have been doing a combination of multi-cap and focused, because we feel that you need diversification at some point and you also need some 10-15% of focused bets in your portfolio. So for us, it’s a combination rather than a binary decision of zero or one.
Amit, I’m not asking whether it’s a binary decision, but my larger question is even though the categorisation is now clear, people get confused whether they should put a larger portion of the portfolio in the multi-cap/focused scenario or should they go for large-cap funds or should they go for small caps? What should the larger portion of the portfolio be?
Bivalkar: I think the larger portion should still go to the multi-cap category, then the focused and then if you want to go for the mid or the small-cap category. We always drive the vehicle looking at the rear-view mirror. If you remember, in October or November 2019, focused funds were in vogue because they had delivered a stellar performance compared to multi caps. So you had more money which was moving towards focused funds and now if you try to look at focused funds, they are 70-80% large cap.
It’s very difficult for an investor to pick large cap or mid cap or small cap. Therefore, a multi-cap portfolio always will make sense. For people who understand concentration risks, I think they should go for focused funds.
Gurmeet, let’s say people don’t mind having two or three categories of equity funds, what should the percentage of categorisation be?
Chadha: Anywhere between 20% to a third of the portfolio, depending upon as Amit was saying decline risk profile. Also, I tell you what is important now for even advisers like us is to look at the stock selection far more carefully. So, you have an SBI Focused Equity Fund, which is 60% large-cap and 40% mid-cap, you have a Motilal Focused which is 90% large-cap. Even in large-cap category, the funds which have done well is Axis Bluechip, in multi-cap like a Kotak Standard Multicap, and just a disclaimer, these are not recommendations. We don’t have enough data because this (focused funds) is a recent category. My basic argument is that unsystematic risk beyond 30 stocks doesn’t add and if you have six multi-cap funds, each having 50 stocks, 70 stocks, you’re virtually actually owning a BSE 500. So I’m saying the right combination is important. I am a little biased towards having focused funds with a good stock selection, right process and two-three different styles. We tend to typically chase performance, as I would say you need to have two-three styles in the portfolio. So you should have a growth style; ICICI, for example, the focus point has a bit of a value style, but some exposure to PSUs and utilities. It is also equally important to build in two or three styles in the portfolio so that you are fairly well diversified.
Amit, do you want to make a point?
Bivalkar: I think what one needs to understand is that the name ‘focused’, one should not paint the entire category with the same brush.
You have different styles, you have different market caps and if you try to look at the corpus sizes, they are most agile today because focus funds are not that big in category as multi-caps.
So the elephant takes long to turn, but maybe your focus can be nimble. Therefore, you might be better off if there is a sudden change in trend in the market. That’s why you might want to look at focused funds today.
Mr. Sahai, tell us about this HSBC Focused Equity Fund. As I understand the NFO is already on, you’re midway through the subscription period. What is this fund all about? What kind of investors should apply?
Sahai: As the name suggests that it is a focused fund. Within the focused fund, the focus would be investing across market capitalisation. So it’s a multi-cap focus and investment would be made across sectors. So it’s a diversified fund as well. In support of the focus fund, I couldn’t have chosen better words than the fellow speakers like Mr. Chadha said in the beginning. While having a focused fund at this stage, one not only is able to minimise non-systematic risk but at the same time, there is a sufficient amount of conviction in the stock-picking and by virtue of having a concentrated portfolio, we want to be able to deliver a decent return. The reason for having a focused fund at this point of time is equally important. What we have seen for some time right now, for a couple of years, maybe even longer, is that there has been a polarisation of profit in all the sectors and the greater the disruption in that particular sector, the higher the polarisation. We have seen this in financials, we have seen this in telecom, airlines, and real estate, you name them...
Amit, you want to come in because you mentioned that focused funds have to kind of declare what is it that they will be doing? Mr. Sahai said that it is spread across categories. Have you had a chance to study this NFO document?
Bivalkar: As advisers you need to have a look at what is the first portfolio which comes out from the fund house and then probably look at it whether it makes sense to put in as one more fund in a client’s portfolio. So we will wait for the first fact sheet to be out and as they say in Covid, that when lives get blurred, you probably need to have some focus. So I think that is the reason why they must have launched a focused fund today.
Mr. Sahai, you were making that point. Please continue.
Sahai: I wanted to add to the point of the fellow panelist who was talking about the first portfolio coming out and talking about the reasons for having a NFO at this point of time. What I was saying is that we are having disruptions across many sectors which means that there are a number of investable ideas and a number of new themes which are emerging on the account of the pandemic; some of them despite the pandemic as well and many of them have got a medium- to long-term runway to go. That can only be done if we have a NFO which is able to invest 100% of the AUM in this kind of thought process. Now, there are certain sectors which we also need to avoid or minimise our investment in and that also has been impacted on account of this pandemic. Now, in case of a legacy portfolio, there might be a case of investment made at that point of time in that particular economic situation but what we believe is that under the current situation, if investment is made in a focused manner, in the themes which is going to benefit on account of this pandemic, that is the better option or the better solution. That is why we thought launching an NFO is a better option. Although in our existing portfolio, where we have large-cap and mid-cap portfolios, within that we have increased concentration, we have reduced the number of stocks, we have got more focused, yet it is an incremental thing. We have thought a full ground-up portfolio building would be a better approach at this point.
Are you saying that starting off the block a large portion of your investing in the focused fund would be themes that could immediately benefit from the pandemic? I mean, it’s a train of thought, but are you doing that?
Sahai: Absolutely because there are certain new themes that have emerged. I think one of the themes is that increasing digital adoption, basically both by consumers as well as by enterprises. This is not only going to be used during the pandemic time, we believe that now this will become the trend going forward. So the companies which are in the businesses of providing higher digital adoption, both by consumers and by enterprises, they’re going to benefit from medium to a longer term.
We are also seeing some global events happening, as a result of which a supply chain shift has been happening. On account of the pandemic, we have realised the vulnerability of having dependence on a particular country or a particular supply chain. So, we need a diversification of that and that’s what the global corporates are thinking and saying. India would be competing to attract those investments, but there are certain sectors where India has got advantages in order to attract these investments. So, those sectors would again be in our consideration. The broader point which I’m making is that in a number of sectors, there is going to be a disruption and there has been a disruption—some of them are temporary, but some of them have got a longer-term impact. And the way to play this is to build a ground-up portfolio to account for these disruptions which are happening in the economy.
Mr. Sahai, you are the head of equities of the AMC, would you be able to tell us what the typical investing pattern be? One is the sectors that we will choose and which is fine. The other is the kind of concentration that you would take. Any thoughts?
Sahai: So, this is going to be a multi-cap approach where roughly the large-gap would be between 60-80%, mid-cap would be something like 10-30% and small-cap would be 0 to 10% or so. There area couple of points which I want to highlight, whether it’s large-cap, mid-cap or small-cap, we are looking at a dominant player in its own sector, which is gaining market share. That is why it is not market-cap dependent. These names could be in the large-cap space but there are many sectors where the sector itself is small; there the dominant player would be in the mid-cap and small-cap space.
The second point from our investment perspective would be that these companies; the dominant player should have a sustainable route to profitability and the sustainability of the profitability should continue from medium to longer term. So we are not necessarily looking at what has happened in the last quarter, what is happening in the current quarter but if the changes which have been brought about because of this pandemic-- for how long can they sustain both on a positive manner and a negative manner and that’s where our focus from our investment perspective would be.
The third angle is that where we are benefiting on the account of the pandemic; that overall market levels are still down 15% from the January peak. To that extent, for many of the ideas, the valuations have become comfortable or at least the correction in the price is significantly more than what could be the disruption in the value of that business. So, to that extent that makes us attractive.
Our investment ideas would be dominant player in each sector gaining market share, sustainable route to profitability, as well as reasonable valuations that would be across market gaps.
What kind of response do you expect to the NFO?
Sahai: This has not come as a surprise. When we were thinking about launching this fund, this was definitely on our mind that in these times when there is so much of uncertainty and that we are not going out and meeting people—all our interactions are happening through the internet, through the digital means basically—we thought there would be challenges on account of the connection. However, we thought that as compared to a scenario when there is a lot more certainty where we can go and meet lot more clients and probably get more as an AUM, from the investors perspective, it is better to invest right now than to wait for a certainty in the economy, certainty in the marketplace, in which case the valuations may not be that attractive. So from the investor perspective, we believe this is a better time to come in. We also have got the next 30-45 days to be able to invest. But when we had to choose between how much money we can raise and how much the investors would benefit, we thought it is better to go for the investor to benefit for.
Gurmeet, Amit said he would want to wait for the first fact sheet to come out before he decides whether this NFO should find a face in the portfolio or not. Any thoughts based on HSBC’s track record or any other thing that you would have looked at which can make you advise our viewers whether they should subscribe or not?
Chadha: I broadly agree with Amit. We do not really suggest NFOs as a policy unless something is a new concept or a theme. The last one we did was the S&P 500 and the Motilal-Nasdaq one which offered diversification, low correlation. The presentation looks impressive to me. They’ve spoken about stocks in the last 10 years where the profit CAGR growth versus contribution to the Nifty EPS—they’ve clearly mentioned the sectors they are overweight and underweight on. They’re overweight on telecom, consumer staples and healthcare, and they’re underweight on utilities, discretionary and industrials. One advantage and disadvantage of the NFO at the same time is that the market timing element is taken care of. The fund manager builds the portfolio, takes time to deploy—it typically takes about two to three months. So people who are a little timing-centric; maybe a very small proportion of investors who have no exposure to focus, maybe a small amount and then building it up to STP could be an option, but broadly for a large set of clients as Amit likely said, we wait for the first portfolio to come in.
Amit, any follow up thoughts on this one?
Bivalkar: So I think shareholders now are valuing demand creators than supply providers and that is very evident from the disruption theme what we have seen in the U.S. in terms of FAANG. So, I think one needs to identify the demand creators within sectors rather than the supply providers. Therefore I said, once you have the fact sheet out then you can actually decide. Another important point is that you were at 400 Nifty EPS in 2018, probably will be at the same Nifty EPS in 2020. So if you want to give a 25 PE-26 PE to the market today, I don’t think so. Therefore, we are going to be somewhat light on equities and therefore we’ll probably wait it out this time.
Since Amit teased the market in the multiples; is that is what investors have thought of as well or your clients, have they made use of this uptick to lighten positions, not just from SIPs from lump sums? Amit, let’s start off with you.
Bivalkar: I think on March 23 when the market hit the bottom, I think a lot of advisers had taken a proactive call to put some money into equity. And I think that profit-taking has happened in the last month. Also, if you try to look at if everybody is working from home, then the amount of new broking accounts which are getting opened at the direct platforms like Zerodha and others, you have seen people who want to dabble into stocks on their own—this typically happens when you have a one way rally and when you have nothing else to do. The stoppage in SIPs what you have seen in the industry if you really dig deep, I think the stoppage is more on the direct clients who have gone because at these times, you actually need somebody to hold on to probably explain what has happened in the markets. And since there is no one, then probably people throw in the towel and stop their SIPs and probably move to bank FDs. So I think the more important reason is that you need somebody to lean on and at this time that is your adviser. Since you don’t have an advisor in a direct plan, I think people have stopped their SIPs. Plus, many guys who had put money in March, they have taken some money off the table.
Gurmeet, have any of your clients expressed the desire or gone ahead and stopped their SIPs or taken money off the lump sum investments?
Chadha: Our SIP book is hardly down 5% and that’s more with cases where there have been unfortunate events of job cuts or salary cuts. So that’s more dependent on the cash crunch rather than the view on the market. In general, our net shares have been positive for the last two to three months on the equity side. Incrementally, there is there is caution. Also large family offices are keeping good cash levels; the reason being that they’re uncertain and you are dealing with an unknown. Look at the way even the moratoriums went up in banks. First quarter, first extension you had; even Bajaj Finance at 27%. So I think some bit of guard was taken to deal with the uncertainty. Also, I think the number has to be looked in more detail. It’s the balanced funds, the equity savings funds, the hybrid funds which have seen the bulk of the outflows. Mind you we had a balanced fund category where 50,000-60,000 crore was only in dividend option, which were paying 0.8 to 1% kind of dividend yields, and people are not really appreciating the dividends actually coming out of capital. Some bit of that realisation also came in. I’m not seeing very large redemptions at least from the set of family offices, and the affluent clients I manage.