A focused fund is a type of mutual fund that invests in a limited number of stocks or bonds. Unlike other mutual funds that spread their investments across different sectors and companies, focused funds concentrate their investments on a few specific sectors or themes. The primary idea is to concentrate investments in areas where the fund managers have strong knowledge or believe there is high growth potential.
Some common examples of focused funds are tech-focused funds (invests primarily in technology companies), healthcare-focused funds (invests in healthcare and pharmaceutical companies), and more.
When it comes to tax implications, the returns from focused funds are subject to capital gains tax. Short-term gains (holding period of less than a year) are taxed at a higher rate compared to long-term gains (holding period of more than a year).
In this article, we will explore what a focused fund is, how it works, and provide examples to illustrate its operation. We'll discuss the advantages of focused mutual funds, identify who should consider investing in them, and highlight important factors to consider before investing. Additionally, we'll cover the tax implications of focused mutual funds and provide guidance on how to invest in them effectively.
What are focused mutual funds?
A focused fund is a type of mutual fund that invests in a small selection of stocks or bonds. These investments share some common characteristics, such as belonging to the same industry or sector. Unlike other mutual funds that spread their investments across many different companies and industries (diversified funds), a focused fund concentrates on just a few areas. This means it doesn't hold a wide variety of investments, but instead, it focuses on a limited number of stocks or bonds within specific sectors.
How do focused mutual funds work?
To better understand how mutual funds work, let’s see where and how these funds invest:
- Focused funds invest in a limited number of stocks: Focused mutual funds concentrate their investments in a limited number of stocks, mostly up to a maximum of 30. This is in contrast to other equity mutual funds that sometimes hold between 50 to 100 stocks entirely depending on their investment goals. By focusing on a smaller number of stocks, these funds run a concentrated portfolio. This concentration allows fund managers to focus their research and investment decisions on a select group of stocks that they believe have strong potential for growth.
There are no restrictions on where they invest: Focused funds have the flexibility to invest in companies from any sector and any market capitalisation. This means they can include large-cap, mid-cap, and small-cap stocks in their portfolio without any restrictions. It is worth mentioning that focused funds are similar to multi-cap mutual funds but with fewer stocks. Fund managers have the freedom to decide how to allocate the fund's money among different types of companies. This allocation is mostly done on the basis of their analysis and market opportunities. Also, this flexibility allows them to capture gains from various segments of the market while maintaining a concentrated investment approach.
The purpose of focused funds
Investing in mutual funds is often seen as a way to spread investments across many companies, providing a safety net against risks. However, this widespread diversification can limit returns, as not all companies perform well simultaneously.
Focused mutual funds are designed to break free from the limitations of broad diversification. Instead of investing in many companies, these funds carefully select a smaller, more concentrated portfolio of stocks and debt funds. While this approach may lack the safety net of diversification, it makes up for it by relying on thorough research in choosing investments.
In simple terms, focused funds are like a curated selection of investments, handpicked for their potential. Yes, they come with more ups and downs compared to widely diversified funds, earning them the names "concentrated funds" or "under-diversified funds." The trade-off is clear: higher risk, but potentially higher returns.
Advantages of focused mutual funds
Focused mutual funds offer several advantages to investors looking to make targeted investments with high potential rewards. By concentrating on a limited number of carefully selected stocks, these funds aim to achieve higher returns. For more clarity, let’s look at some of their major advantages:
High potential returns
Focused mutual funds can offer high potential returns because they invest in a limited number of stocks that the fund manager strongly believes will perform well. Unlike diversified equity funds that spread their investments across many companies to reduce risk, focused funds concentrate their capital on a few select stocks. If these chosen stocks perform well, the returns can be significantly higher, especially in a polarised market where only a few stocks outperform.
Risk
While focused funds have the potential for high returns, they also come with higher risk. The risk in these funds depends on how much of the portfolio is invested in equities. As a thumb rule, the more equity in the fund, the higher the risk. It is worth mentioning that the risk level of a focused mutual fund depends not only on how much of the fund is invested in stocks but also on which specific types of stocks the fund invests in and the investment strategy it follows.
For example, investing in volatile tech startups is riskier than investing in established blue-chip companies. Similarly, a strategy aiming for quick capital gains is generally riskier than one focusing on stable, long-term growth. Also, focused funds are more volatile when compared with hybrid or arbitrage fund, which usually mix equity and debt or focus on low-risk strategies.
Diversification across company sizes
Focused funds can invest in companies of any size, including large-cap, mid-cap, and small-cap companies. This flexibility allows the fund to diversify its investments across different market capitalisations. Moreover, the fund can adjust its allocation between these company sizes based on market conditions. This way, investors get exposure to a portfolio that is diversified across company sizes and can adapt to changing market dynamics.
Exposure to handpicked stocks
It must be noted that since focused funds invest in a maximum of 30 stocks, fund managers spend a significant amount of time and effort in selecting these stocks. They conduct in-depth research to ensure that only the best-performing stocks are included in the portfolio. This thorough selection process increases the chances of earning better returns compared to the broader stock market.
Diversification across sectors
Even though focused funds invest in a limited number of stocks, they have the flexibility to choose these stocks from any sector. This means the fund's portfolio can be diversified across different industries. Such diversification reduces the risk associated with any single sector. By selecting top-performing stocks from various sectors, the fund can create a balanced and potentially high-performing portfolio.
Who should invest in focused mutual funds?
Ideally, focused mutual funds are best suited for investors who are comfortable with higher risk and have some investing experience. Also, it is ideal if investors can commit to a long-term investment horizon of at least five years to realise potential returns. Let’s understand this in detail:
Investors who have an appetite for risk
Focused mutual funds are riskier because they invest in a limited number of stocks. The fund manager selects stocks they believe will provide high returns. Due to such a concentrated approach, if one stock performs poorly, it can significantly impact the fund’s overall performance.
Therefore, only investors who are comfortable with taking on more risk than they would with a diversified mutual fund should consider these funds.
Investors with some investing experience
If you’re new to investing, focused funds might not be the best starting point. That’s because these funds are more volatile in the short to medium term compared to multi-cap funds, which spread investments across various sectors and companies.
Investors with a few years of experience and a good understanding of market risks are usually better suited to handle the fluctuations of focused funds.
Investors with at least a 5-year investment horizon
Focused mutual funds are equity-based and, consequently, require a longer time to realise their full potential. Additionally, since these funds make selective investments, it can take time for those investments to pay off.
Therefore, investors should be prepared to stay invested for at least five years to see significant returns. If you can commit to this longer time frame, focused funds might be a suitable option for you.
Tax implications on focused mutual funds
The tax rules for focused mutual funds are similar to those for other equity funds. If you hold your investment for more than 12 months, any gains you make are considered Long-Term Capital Gains (LTCG) and are taxed at 12.5% if your total gains for the year exceed Rs. 1.25 lakh. Whereas, if you sell your investment within 12 months or less than 12 months, any gains are considered Short-Term Capital Gains (STCG) and are taxed at 20%.
Risks involved with focused funds
- Concentration risk: The concentrated nature of focused funds means that poor performance in a specific sector or theme can have a more significant impact on the overall portfolio.
- Market volatility: Focused funds may be more susceptible to market fluctuations, as their performance is closely tied to the success of a limited number of holdings.
- Managerial risk: Success in focused funds relies heavily on the fund manager's ability to make sound investment decisions. A change in management could potentially impact the fund's performance.
Are Focused Mutual Funds Right for You?
Focused mutual funds are suitable for investors who are comfortable with a higher level of risk and are seeking potentially higher returns. Those who have a good understanding of the specific sector or theme the fund focuses on, may find these funds aligning well with their investment goals.
Despite the risks, these funds are expected to get more popular in the future. Why? Because of their high risk and high reward nature, these funds have the potential to generate better returns compared to other mutual funds with a more diversified portfolio.
Things to consider before investing in focused mutual funds
Before investing in focused mutual funds, investors must understand its concentrated portfolio strategy. That’s because the approach of targeting a limited number of stocks can enhance returns but also increase risk. Additionally, consider your risk tolerance, investment horizon, and the fund’s track record before investing. For a sound investment choice, always consider these key things to make an informed decision:
Risk
Focused funds invest in a maximum of 30 stocks, which means they have to put significant amounts of money into each stock. Due to this concentration, they are not as diversified as other funds like multi-cap funds. This lack of diversification makes them riskier, as poor performance in just a few stocks can heavily impact the fund’s overall returns.
Returns
In certain market conditions, known as polarised markets (where only a few stocks outperform others), focused funds can outperform diversified funds and the broader market. If the stocks chosen by the focused fund are among those that are outperforming, the returns can be very high. However, if the market performs well across a wide range of stocks (broad-based rally), the focused fund might not deliver returns that justify the higher risk.
Cost
For the unaware, the expense ratio is the percentage of your investment used to manage the fund. A lower expense ratio means more of your returns stay with you rather than going towards management fees. Therefore, when investing in focused funds, it’s important to choose those with a low expense ratio to maximise your returns.
Investment horizon
Focused funds can be volatile in the short term because they are concentrated in a limited number of stocks. If you’re looking to invest for a short period, these funds might not be suitable due to this volatility. Instead, you should be prepared to invest for a longer period (at least five years) to give the fund time to potentially deliver better returns.
In conclusion
Focused mutual funds offer a unique and concentrated approach to investing, with the potential for higher returns but also increased risks. As with any investment decision, thorough research, and careful consideration of your financial goals are essential steps to ensure that focused funds align with your overall investment strategy.
