Have concentrated funds been able to cherry pick?
Pasta is one of world's most favourite foods. According to International Pasta Organisation, on an average, per head consumption of pasta in Italy is about 26 Kg. Venezuela, Tunisia, Chile and Peru are among other countries where pasta is a part of everyday meal of many people. In India too, it is rapidly gaining popularity. Be it so; but can anyone imagine oneself eating only pasta in lunch and dinner because it tastes good? Unlikely right? Why do we eat variety of foods? It is because no single recipe can provide us all nutrients in right proportions as needed by our body. Then why should you think that common stocks of few companies bought in high proportions would contain everything that your equity portfolio needs? At least some mutual fund houses think so.
Performance of Concentrated Funds Vis-a-vis Various Categories
In December 2007, Religare Mutual Fund launched India's first concentrated fund, Religare AGILE, which follows a quantitative technique for determining the attractiveness of securities. Reliance Mutual Fund followed suit by launching a similar fund, Reliance Quant Plus in April 2008. Thereafter the idea of concentrated funds seems to have made headway. JM, ICICI Prudential, Sahara and DSP BlackRock launched concentrated funds investing in 15-25 stocks, though none of them explicitly stated to follow the quant model. Before we talk about the performance of these funds let's understand the nitty-gritty of concentrated funds.
Diversification Vs Concentration:
Diversification, be it across asset classes or within a particular asset class, aims to reduce the volatility in the portfolio return. This is one of the basic purposes of investing in mutual funds. When you hold a well researched portfolio of stocks across sectors, chances of losing money drastically reduce. However, proponents of concentrated investing argue that over-diversification serves no purpose as it doesn't help in reducing the volatility in the portfolio returns. Now the moot question is how many stocks a mutual fund should ideally buy to reduce risk. The widely accepted modern portfolio theory has scientifically proven that an inclusion of an additional stock up to 20th stock in the portfolio helps in reducing the volatility (risk). On the other hand, the father of value investing, Benjamin Graham, in his masterpiece "The Intelligent Investor", states that 10-30 stocks can give you adequate diversification to even out the non systematic risk (risk that can be eliminated through diversification). This supports the idea of investing in 15-25 stocks and still enables you to attain enough diversification. Importantly, concentrated portfolios are constructed to earn greater returns at optimum level of risk.
Portfolio structure of concentrated funds :
Portfolio composition plays an important role in the success of any fund be it a large cap or a multi cap. In the case of concentrated funds the portfolio composition is considered even more crucial as there is not much margin for error or misjudgement as equities are bought in high proportions and fund may suffer severe losses if its bets don't work. Let's now understand how these funds construct their portfolios.
Religare AGILE aims to invest in 11 stocks obtained as a result of quantitative analysis in equal proportion i.e. 9% each. The portfolio is reviewed on a monthly basis and changes are made based on the data generated by the model. It has imposed 3 conditions however, viz. the free float market capitalisation of the stock should be equal to or higher than that of the last stock of S&P CNX Nifty, the stock should have a price history of at least 1 year and the industry represented by the stock should be present in the composition of S&P CNX Nifty. Reliance Quant Plus, based on, price action and fundamental analysis of stocks, selects 15-20 stocks for the portfolio. The portfolio is reviewed on a weekly basis and changes are made based on the data generated by the model. The fund may also invest in derivative upto 50 % of its net assets at discretion of fund manager.
ICICI Prudential Focused Bluechip Equity invests in around 20 companies belonging to the large cap space. The portfolio is mandated to select stocks from among the top 200 stocks in terms of market capitalization on NSE. The fund follows bottom-up approach for constructing its portfolio and the fund manager has flexibility to choose between stocks across all themes, sectors and investment styles. On the other hand Sahara Super 20 invests in equity and equity related securities of around 20 companies selected out of the top 100 largest market capitalization companies, at the point of investment. DSP BlackRock Focus 25 invests in a portfolio of about 25 companies which are amongst the top 200 companies by market capitalisation. The portfolio will limit exposure to companies beyond the top 200 companies by market capitalisation upto 20% of the net asset value. JM core 11 holds a concentrated portfolio of stocks with minimum exposure to each stock being 9.09%. The fund seeks to rebalance the portfolio on a fortnightly basis so as to prevent any one stock going above the targeted concentration range. To prevent stagnancy of the portfolio, the portfolio will be reviewed on a half yearly basis whereby some stocks would be replaced. It is noteworthy that all the funds mentioned above are being benchmarked either against the BSE Sensex or the S&P CNX Nifty. By and large, these funds invest in large cap stocks only and hence benchmark their performance either against the BSE Sensex or S&P CNX Nifty.
But how have they performed?
Well, the performance of concentrated funds has been rather lacklustre, particularly in comparison with the performance of other categories.
NAV data is as on March 16, 2012. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period.
|Category Average of Mid Cap Funds
|Category Average of FlexiCap Funds
|Category average of Large Cap Funds
|Category Average of Concentrated Funds
Risk-free rate is assumed to be 6.37%
(Source: ACE MF, Personal FN Research)
Table above reveals that the category average of concentrated funds has been ordinary. They collectively have not only underperformed the other categories across the time frames but have also disappointed on the risk adjusted returns parameter.
And Individual Performances...
NAV data is as on March 16, 2012. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period,
and thus are reflecting in case of only those funds which completed a 3-Yr track record.
Risk-free rate is assumed to be 6.37%.
(Source: ACE MF, Personal FN Research)
Individual performances too aren't encouraging either; barring ICICI Pru Focused Blue Chip Equity which has managed to craft an impressive track record for itself. It has managed to beat large cap indices, BSE-Sensex and S&P CNX Nifty with a noticeable margin, but when compared against the top performance of other categories returns generated by the fund don't appear extraordinary.
JM Core 11 has been the most striking example of what can happen to your investment if the fund is not adequately diversified. The fund started out as a flexi cap concentrated fund. For first two years, it invested heavily in infra sector. To add more risk (with an anticipation of generating supernormal returns) it dabbled in Futures and Options (F&O) space as well, thereby taking exposure to risky derivative contracts of individual stocks, not for hedging, but for creating a alpha. But all these strategies turned self-destructing, especial when the markets took a downswing (on account of the U.S. sub-prime mortgage crisis). And even today, while the Indian equity market has recovered from the lows of March 9, 2009 the fund has only managed to blow up investors' money (by delivering -23.0% CAGR, since inception returns) and has never returned even to its par value.
This seems to have created a long lasting impact on every fund house managing similar schemes. These days, fund houses, including JM, invest mainly in large cap index constituents. Interestingly, funds following quant strategy have also fallen flat with no extra-ordinary performance. Moreover, these funds have indulged in excessive portfolio rebalancing which has resulted in higher portfolio turnover.
Although there is enough academic evidence that a portfolio of 20 odd stocks, or a little more may give you adequate diversification, mutual funds seem to have forgotten the important assumption of the theory. "The portfolio diversified across sectors shares low correlation". Take for instance, Sahara Super 20, it has invested 40.4% of its assets in interest rate sensitive sectors such as Banking, Finance, Auto and Construction. However, it has no exposure to defensives such as pharmaceuticals which share lower correlation with the rate sensitive ones. In such cases portfolio of 20 stocks cannot eliminate the non-systematic risk. Another shortcoming in the functioning of these funds has been that even the similar strategies are yielding variant results. For example, Reliance Quant Plus and Religare AGILE both follow a quantitative model and invest in the S&P CNX NIFTY constituents but the sectorial pattern of their portfolios has been quite paradoxical. As per the portfolio disclosed on January 31, 2012, Religare AGILE invested about 28% of its portfolio in the cement sector, while Reliance Quant Plus as per the latest portfolio disclosed on February 29, 2012, had no exposure to cement sector. This in turn means that either Religare AGILE sold off its entire holdings in cement sector in February (as the fund has not disclosed its position on February 29, 2012 as yet) or it continued to hold cement as its top sector. Either of the outcomes is equally confusing. This gets us thinking as to which quantitative model generates result which are as different as chalk and cheese.
We believe that investors should not fall prey to such fancy fads. As seen above, the modus operandi of concentrated funds keeps many questions unanswered. Those who want to restrict their investments to large caps may invest in pure large cap funds which enjoy more flexibility than these concentrated funds. And those, who want to benefit from opportunities arising in the specific sectors/stocks, may invest in opportunities funds. As per Securities And Exchange Board Of India (SEBI) Guidelines, single stock exposure at the time of investment cannot be in excess of 10% of its net assets. In other words, no law stops opportunities funds from investing 10% of its assets in a single stock. However the problem starts when a fund is mandated to hold only 10 or 15 stocks in the portfolio. Due to such structure, the fund will be compelled to hold a concentrated portfolio of few stocks, where not necessary the conviction may result in luring returns.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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