Rationale Behind Concentrated Portfolios

There is a category of equity MFs which invest in 25 or say 35 stocks only. This concentrated portfolio equity mutual fund strategy is marketed as an aggressive management. But when we speak about mutual fund benefits, the important point is DIVERSIFICATION. If a portfolio is concentrated in few stocks or few sectors, will it increase risk? Will the returns also increase with an increase in risk? Let’s try to understand.

Portfolio Concentration increases concentration risk.

Warren Buffet has also put his view on portfolio concentration strategy and he favors it.

So stock professionals always favors a Concentrated Portfolio – Because he knows what he is doing.

Before we take a decision let’s know this in details

What is Portfolio Concentration?

Diversified Equity Mutual Fund Schemes hold stocks of a number of companies in their portfolio. Generally, such funds hold anywhere between 40-75 stocks in the portfolio.

Many of these funds are over 5000 Cr. So if you have 50 Companies on an average you have put 100 Cr per stock. This is also a very large number. Also, note that typically a fund holds 20-40 percent in top 10 stocks only.

However, there are some schemes that hold only 20-25 stocks in their portfolio. Such schemes are said to run concentrated portfolios. An example could be DSP BR Focus 25 Fund or Motilal Oswal MOST Focused 35 Fund.

Portfolios can be concentrated with stocks and sector too. Some funds hold high weights to a particular sector making themselves concentrated. In equity Funds, currently, many funds have weights as high as 40-50%to the banking and financial services or infrastructure space. Eg DSP BR Opportunities Fund which is over 35% in Banking & Financial service sector.

In these schemes, the top 5 to 10 holdings in the portfolio constitute more than 50% of the Portfolio.

Analysis of Concentrated Portfolios in Equity Mutual Fund

Concentrated Funds will hold a lower number of stocks than the normal funds.

In Mutual Funds, the concentrated folio is fund manager or his team driven portfolio. They are free to extend normal sector allocation limits or stock limits. These are marketed as “the Fund Manager ‘s best ideas”.

The aim is to take higher exposure in certain stocks here conviction is of higher degree. The main objective is to generate higher alpha (excess returns) when markets favor the concentrated stocks.

Generally, the top 10 ideas would constitute as much as 50-60% of the total portfolios. Look at the portfolio concentration of Axis Focused 25 Fund & its Large Cap Fund Axis Equity Fund:

While diversified Mutual funds hold about 35-70 stocks in their portfolios and then hold small amounts generally not exceeding 5% in each stock. So they rarely bet on 1-2 stocks. On the other hand concentrated funds eliminate small holdings while ensuring that the same benefits of diversification are there.

Concentrated Portfolios Risk

The word “Concentration Risk” comes from banking. If you loan one type of sector like steel and if steel prices suffer due to global reasons, the lenders will have a hard time. They will delay or default payment. This risk is calculated using a “concentration ratio”. This ratio explains what percentage of the outstanding accounts each bank loan represents. So they follow the principle of diversifying the sectors by allocating targets.

In Equity Funds also with concentrated holding, the fund can face extreme volatility or can suffer from periods of under-performance. If a Fund Manager has a large position in one or 2 stock and the call goes wrong due to xyz reason, it could take a long time to recover losses. This is because large holding is hard to sell for a losing stock.

So a concentrated fund can have:

• Liquidity Risk
• Price Fluctuations both ways
• Under-performance or Over performance for a stretched period of time.

In fact, the concentrated portfolio is a risky game for both fund managers & investors. So risk should be the judging criteria to buy or not.

Concentrated Portfolio Vs Diversification

Most of the fund houses keep internal policies for single stock exposure or single sector exposure. Even many concentrated funds do not invest more than 10% of their assets in a single stock. They can go up to 12-15% after the trustee’s approval.

When you deal (manage or buy) a concentrated portfolio, the thing that works in mind is –

CONVICTION IN OVERWEIGHT COMPANY or SECTOR.

It is, not the case “who will be the man”? It is a case where you have to look at your portfolio need.

If I am a full-time investor and my core job is studying and locating companies with inherent strength I will go for a concentrated portfolio. That is the reason PMS fund managers or Equity Investing Firms stick to 10-15 stocks.

But, if I am not a full-time investor and cannot face/do not require the risk of a concentrated portfolio, I should stay away from “returns race” and look for a diversified portfolio.

Even then if I want to add some concentrated stocks to my “satellite” (not to the core) portfolio I may use active portfolios from mutual funds instead of direct equity exposure. This way I can minimize my risk as MF portfolio will contain say 25-35 stocks. If an investor goes directly in the stock market there is a good amount of possibility that he may choose very few stocks without actually doing any substantial research.

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