Focused funds are for investors seeking alpha: Should you invest?

Consider these funds after you have a core portfolio in place

UTI Mutual Fund’s (MF's) new fund offer for a focused equity fund is on at present (it closes on August 18). The focused category has 27 funds with total assets under management of Rs 77,747 crore. According to the Securities and Exchange Board of India’s definition, these funds can invest in up to 30 stocks, and must have at least 65 per cent of their assets in equities. 

Promise of outperformance  

These funds have the potential to generate alpha (outperformance over their benchmark). The fund houses put their high-conviction ideas into the portfolios of these funds. Fund managers are also able to take higher allocation to individual stocks than is possible in a diversified portfolio.

“If these high-conviction calls play out, there is reasonable potential for alpha generation vis-à-vis the broader market indices,” says Sudhanshu Asthana, executive vice-president and fund manager, UTI Asset Management Company.

Portfolio management services (PMS) offer investors the opportunity to invest in concentrated portfolios. “The idea behind launching our focused fund was to give investors a product with a similar risk-return profile as a PMS, albeit at a lower cost,” says Jinesh Gopani, head of equity, Axis MF, which runs the largest fund in this category. PMS also has a high entry barrier of Rs 50 lakh.

Another factor that works in their favour is that they can be market-capitalisation (m-cap) agnostic. “The fund manager has the flexibility to invest across m-caps,” says Gaurav Misra, co-chief investment officer, Mirae Asset Investment Managers. According to him, 30 is a large enough number to create a well-diversified portfolio, provided adequate care is taken both in stock selection and portfolio construction.

Volatility can be high

Investors should be prepared for a high draw-down in these funds. One fund in this category showed a one-year return of minus 38 per cent on March 23, 2020.

Since allocation to individual stocks is higher than in a diversified fund (they hold 30 stocks, compared to 45-65 in diversified peers), stock selection becomes critical. When the going is good, these funds can make you a lot of money, but they can also lose out on returns if a couple of stock selections go awry.    

Should you invest?

Investors who are comfortable with volatility in equities in the short term may invest in these funds. Says Viral Bhatt, founder, Money Mantra: “These funds are better suited to experienced investors who tend to have a higher risk appetite.” First-time investors, or conservative investors with a low appetite for volatility, should steer clear.

Market valuations are above long-term averages at present, causing worries about a correction in the near future.

“The outlook for the corporate sector is quite robust. So, one can invest even at these levels. However, do so in a staggered manner,” cautions Misra. In other words, adopt the systematic investment plan or the systematic transfer plan route.

Since stock-picking ability will play a crucial part in the performance of these funds, select the fund manager with utmost care. Besides considering returns on the upside, also check the maximum draw-down during downturns and whether you will be able to stomach that. 

Invest only if you have a long investment horizon. Asthana suggests investing with at least a six- to seven-year horizon.

First, get your core portfolio in place.

“Get your asset allocation right. Then take adequate allocation to large-cap, mid-cap, and international funds in your core portfolio. Only after doing all that should you consider investing in these funds,” says Prateek Mehta, co-founder and chief business officer, Scripbox.