Mutual fund companies allow investors to invest in selected sectors and companies through focused funds. Instead of a diverse mixture of equity shares, these funds invest in designated stocks, roughly about 20-30 company stocks. The objective of these funds is to deliver higher returns by selecting performing stocks. Because of the mandate for choosing only a limited number of equities, these funds are called ‘best idea funds’.
Let’s understand: what are focused mutual funds?
Purpose of focused funds
General mutual funds allow investors to diversify their investment as most funds invest in up to a hundred companies. Fund managers divide the inevitable corpus between equities, spread across sectors, in a predetermined weight. It helps in limiting risks and volatility. But on the flip side, these funds also present some limitations, like, limiting profit-earning abilities.
When the fund is spread across various sectors and companies, it dilutes earning potentials since all companies can’t outperform at the same time.
Focused funds tackle this problem by concentrating investment on a small group of performing stocks. These funds don’t offer the benefit of diversification and hence, are slightly riskier than diversified mutual funds. But fund managers put extensive research into selecting the stocks, which keep the risk factors manageable.
Because of its unique character, focused funds are also called concentrated funds or un-diverse funds. Focused funds can invest in equities as well as in debt instruments following the purpose of the fund.
These funds invest in a small number of investment tools related to each other. There is also no restriction on market-cap, meaning they are like multi-cap funds and give fund managers the freedom in any category, large-caps, mid or small caps.
Primary advantages of focused funds
Following are the benefits of focused funds.
Higher returns: Diversified portfolios invest in multiple stocks to minimize risk. But it also dilutes profit opportunities, especially in a polarised market, where only selected stocks outperform. In focus funds, fund managers invest in a restricted number of scrips with better performance potential and negate the limitations of multi-cap funds.
Risk: Focused funds carry higher risk because of the concentration of funds. But hybrid funds are also not devoid of risks.
The risk mainly arises from the equity exposure of the scheme. Higher equity exposure means higher peril of market volatility. On the other hand, debt instruments run the risk of changing interest rate regimes and capital gains. A fund generating returns only from interest income may be less risky than a fund that relies on earning capital gain.
Diversification across company size: Focused fund managers have the freedom to invest in any company irrespective of market capitalization. These function as multi-cap funds. Moreover, they can change the split across companies depending on changing market conditions. So, investors get a diversified portfolio that is also flexible to adjust to the evolving trends.
Better researched stocks: Focused funds have the highest limit of investing in no more than 30 stocks. It allows fund managers more time to research and select stocks. As a result, they build a portfolio with best-of-the-breed company shares with a better chance to earn higher returns.
Investment across sectors: With a limited number of stocks, focused funds can invest in any industry. It allows fund managers to build a diversified portfolio.
Pros and cons of investing in focused funds
Mutual funds usually allow investors to own a diversified portfolio without taking the hassle of stock picking. Most mutual funds would invest in various companies across market capitalizations and sectors to offer diversified investing experience. It lowers market risks and volatility. Fund managers allocated funds according to a pre-decided weight. But some investors feel that it limits their scopes of earning higher returns when one sector is performing exceptionally well. They solve the problem by investing in focused funds. These funds focus on an industry or companies usually related to each other to capitalize on their growth spurt.
However, while creating scopes for higher profit, focused funds compromise on diversification. Also, it increases investment risks, especially when the market is volatile.
Who should invest?
Focused funds appeal to a specific section of investors.
Investors with a risk appetite: Investors with a higher risk appetite invest in focused funds.
Focused funds invest in a limited number of stocks concentrating on one sector for higher returns. But it also means that if one bet goes wrong, it will result in substantial loss. So, investors with an appetite for higher risk invest in focused mutual funds.
Investors with investing experience: If you are new to investing, these funds are not appropriate. It is because these funds are usually more volatile than multi-cap funds in the short and medium term. If you are a beginner, don’t invest in focused funds as they require some investment experience.
Investors with a long investment horizon: While investing in focused funds, one should have at least an investment horizon of five years. It is because focused funds are equity funds, which tend to perform when given time in the market. Additionally, these funds invest in selected bets, which may take time to show results. So, you should only invest in such funds if you can stay invested for a longer horizon.
Things to consider
Risk: Focused funds invest in 30 stocks at the most, which means higher exposure in each share. It results in the portfolio not being genuinely diversified, which increases the risk exposure of these funds.
Returns: returns from these funds can beat the returns from multi-cap funds in a polarised market condition.
A polarised market means that some stocks or some sectors drive the market and outperform the broader market. If the stocks picked in the focused fund are part of the growing segment, you will receive outsized returns. But if the market rally is more board-based, you might not see sufficient returns from these stocks compared to the risks taken.
Cost: Expense ratio signifies the percentage of funds channelized for managing your investment. While selecting a mutual fund for investment, look out for funds with a low expense ratio because a higher expense ratio will reduce your income.
Investment horizon: Since these funds invest in limited stocks, these funds experience high volatility during short and medium terms. If you are investing only for a short period, consider debt funds. You should invest for at least five years to realize returns from these funds.
Taxation and focused mutual funds
After understanding what are focused mutual funds, let’s understand tax implications.
The taxation on focused funds is similar to the other equity mutual funds. These funds can invest in tax-saving equity funds, non-tax saving equities, debt funds, SIP and more for a limited number of companies. Tax levied depending on the duration of the holding. If you invest in the equity funds for more than one year, the earnings are classified as long-term capital gain and taxed at a rate of 10%.
Equity funds: The focused equity funds are liable to be taxed on short-term and long-term capital gains. Long-term gains for an investment period of more than one year are taxed at a rate of 10% for an amount exceeding Rs 1 lakh in a year.
Short-term capital gains are taxed at a 15% rate for units redeemed before one year.
Debt funds: Long-term capital gains from debt funds are taxable at a rate of 20% after applying for indexation benefits.
Indexation implies readjusting the purchasing price of the units against the inflation rate that lowers the tax burden on the capital gain.
Focused funds are specialized mutual funds to offer higher returns in a polarised market when one sector or stocks outperforms. But it also comes with significant risks of market volatility because of the higher concentration of funds in a handful of stocks.
Now that you have understood what a focused equity fund is, research if it fits into your overall investment plan before betting.
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What are focused mutual funds?
Focused funds are equity mutual funds that invest in a concentrated portfolio of not more than 30 stocks, often from specific sectors. The idea behind this is to select the best-performing shares that can deliver higher returns. However, there is no limitation to market cap or sectors where the fund managers can invest.
Is a focused fund better than diversified multi-cap funds?
Both funds have different investment objectives. A diversified equity fund invests in a large number of securities, offering diversification and risk reduction. On the other hand, a focused fund aims to give the highest returns possible by selecting a limited number of best-performing stocks.
Is there any lock-in period in focused funds?
No, focused funds don’t come with lock-in. You can redeem your units anytime.
Should I invest in focused funds?
Focused funds work well for investors willing to take higher risks by investing in a concentrated portfolio for higher returns. If you don’t have a risk appetite, focused funds are not the right option for you.
Are focused funds risky?
Focused funds are riskier than equity mutual funds. There are two types of risks associated. Firstly, these are equity funds, hence, carry market volatility risk. Secondly, they invest in a concentrated portfolio, which increases the risk of not being diversified enough.
How long should I remain invested in focused funds?
Focused funds offer better returns over a long time horizon. One must invest for at least five years to earn good yields from these schemes.
Can I set up a SIP plan on focused funds?
Yes, you can start a systematic investment plan with a focused fund. It offers you the flexibility to select the amount and frequency of investment. The amount will get automatically deducted from your account and invested in the funds of your choice.