We’re almost sure that most people, including you, would not concentrate your entire portfolio in equity funds.

Portfolio concentration in equity mutual funds is a risk that most investors tend to avoid.

But why so?

In most cases, it is seen that retail investors have limited knowledge with respect to risk-return, asset allocation and portfolio construction.

The distributors, in this case, tend to not disclose the risk related to concentration in a portfolio (if any). This has resulted in investments crashing sooner or later, leaving behind the investors unnerved.

It is often observed that equity mutual funds with a large chunk of assets are biased towards a handful of stocks.

This defies the objective of investors to use mutual fund schemes for generating alpha over the benchmark, while diversifying an overall portfolio.

We believe before taking a position in any fund, an investor should take into account the pros and cons of the fund and analyze it from a 360-degree angle to get a comprehensive view.

What should an investor’s approach be?

There is no thumb rule that defines how much of the portfolio corpus should be invested in the top five or top ten stocks of a fund.

Typically, it is seen that a fund manager in India tends to put the money in the same set of stocks.

We have analyzed multiple funds in the large-cap category and found that the typical concentration has increased to as high as 30% for the top five stocks.

In general, it is observed that a fund should not have more than 50 percent allocation for the top ten stocks.

Should there be a situation of rising concentration, there is a reduction in the returns level.

Thus, while investing, an investor should be wary of the portfolio’s concentration, given the fact that a portfolio’s return typically tends to decline with rising concentration.

Is a concentrated portfolio beneficial?

Not all concentrated portfolios show a declining trend.

While the risk parameters are typically higher for a concentrated portfolio, they have their own benefits as well.

For a fact, some of the best known investors, such as Warren Buffett, employ concentrated portfolio strategies. In the words of Buffet, a portfolio should not have more than 10 to 12 scrips.

                                                                             Buffet says

“I cannot understand why an investor elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the businesses he understands best and present the least risk, along with the greatest profit potential”

Benefits of a concentrated portfolio

In reality, a portfolio manager who adopts a concentrated style of investing, tries to exploit his/her best ideas. This also results in lower monitoring cost when compared with a large portfolio.

1.Improved and focused research

With a sizeable sum of money invested in one stock, the investor is forced to ensure that the prospects of the share are good, thereby resulting in better research.

2. Performance Oriented

With a limited number of shares in a portfolio, the fund manager tends to look after each share and take corrective action with respect to average cost and profit.

3.Better returns

If the research is conducted properly, the result provides better returns.

A classic example of a concentrated fund is, Motilal Oswal MOST 35 Multi-cap Fund :

Word of caution

To conclude, we believe an investor should be alert of the fact that just because a fund manager holds fewer securities it is not likely to outperform a diversified fund and vice-versa.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww