Focused Funds vs. Diversified Funds – Which one Should you Choose?

We have all heard of the well-known saying in the investing world: "Don't put all your eggs in one basket". The saying emphasises the importance of diversification. While diversification is important; beyond a certain point, it doesn't reduce the risk further. Hence, as an investor, you neither need concentration nor over-diversification. Investors can consider focused funds to get just the right amount of diversification. This article will discuss: Focused funds vs. Diversified Funds – Which one should you choose?

What are Focused Funds? 

A focused fund is an open-ended equity scheme that invests in a maximum of 30 stocks. The scheme needs to mention its focus area (large, mid, small, or flexi-cap). A focused fund has to invest a minimum of 65% of its total assets in equity and equity-related instruments.

Focused funds usually follow a market capitalisation, sector, and theme agnostic approach. Since these invest in a maximum of 30 stocks, focused funds can be considered a concentrated form of a flexi-cap fund. Although focused funds also follow a diversified approach, the diversification is limited to 30 stocks as per the product structure defined by SEBI.

When should you invest in Focused Funds?

Once an investor has adequate exposure to diversified equity funds, as explained above, they can consider investing some amount in other equity mutual funds. These can include focused funds, sectoral funds, thematic funds, factor-based funds, etc. Ideally, the exposure to these schemes should not exceed 20-25% of the overall equity mutual fund portfolio.

List of focused funds for reference:

As of 8th April 2022, 26 focused mutual fund schemes are being offered by various AMCs. Some of these include

1. IIFL Focused Equity Fund
2. SBI Focused Equity Fund
3. Sundaram Focused Fund
4. Axis Focused 25 Fund
5. Quant Focused Fund
6. Nippon India Focused Equity Fund
7. Franklin India Focused Equity Fund
8. ICICI Prudential Focused Equity Fund
9. Aditya Birla Sun Life Focused Equity Fund
10. Motilal Oswal Focused 25 Fund

Taxation of Focused funds

As per SEBI guidelines, focused funds have to invest a minimum of 65% of their total assets in equities at all times. Hence, from a taxation point of view, focused funds are classified as equity funds and taxed accordingly.

1. Short-term capital gains (STCG) tax: If you sell your focused mutual fund units within twelve months of purchase, the capital gain will be classified as short-term capital gain (STCG). The short-term capital gain (STCG) tax will be levied at 15%.
2. Long-term capital gains (LTCG) tax: If you sell your focused mutual fund units after twelve months of purchase, the capital gain will be classified as long-term capital gain (LTCG). Every financial year, the first Rs. 1 lakh long-term capital gain will be exempt from taxation. The incremental long-term capital gain above Rs. 1 lakh will be taxed at 10%.

What are Diversified Funds?

A diversified equity fund is an open-ended equity scheme that invests most of its assets in equity and equity-related instruments. Diversified funds usually have a portfolio of 50-100 stocks spread across various sectors. Diversification reduces the portfolio risk. If one set of stocks is not performing as expected, the outperformance of other stocks makes up for it, and the overall portfolio does well.

When should you invest in Diversified Funds?

It is recommended that an investor should start investing in equity mutual funds with diversified funds.

1. From within the diversified mutual schemes, an investor can choose from active mutual fund schemes such as large, mid, small, multi, or flexi-cap funds. 
2. An investor can also choose from index funds with underlying benchmarks such as Nifty 50, Nifty Next 50, Nifty 100, Nifty Midcap 150, Nifty Smallcap 250, Nifty 500, etc.

Diversified Funds are very vast to discuss. So for easy comparison between the Focused and the Diversified Funds, we have taken a category of Diversified Funds called Flexi-cap funds. A flexi-cap fund is an open-ended fund that invests a minimum of 65% of its total assets in equity and equity-related instruments across large, mid, and small-cap stocks.

List of Flexi-cap funds (A category of Diversified Funds) are given below for reference:

As of 8th April 2022, 31 Flexi-cap mutual fund schemes are being offered by various AMCs. Some of these include

1. Parag Parikh Flexi Cap Fund
2. Quant Flexi Cap Fund
3. PGIM India Flexi Cap Fund 
4. UTI Flexi Cap Fund
5. Canara Robeco Flexi Cap Fund
6. Edelweiss Flexi Cap Fund
7. IDBI Flexi Cap Fund
8. DSP Flexi Cap Fund
9. Union Flexi Cap Fund
10. SBI Flexi Cap Fund

Difference between Focused Funds and Flexi-cap (A category of Diversified Equity) Funds

For comparison purposes, we will compare Focused funds with Flexi-cap funds within the diversified equity funds space. Now let us look at the differences between them.

Who should invest in Diversified Funds and Focused Funds?

All equity mutual funds, whether diversified or focused funds, carry a certain amount of risk and are meant for investors with a suitable risk appetite. However, the degree of the risk varies with the type of equity mutual fund. So, a focused fund with a concentrated portfolio of limited stocks carries relatively higher volatility and risk than a diversified fund.

Chart: Focused fund – Potential risk and return

The above chart shows the risk involved in a focused fund is higher than in diversified funds. The return potential of an active fund is also higher than diversified funds.

Focused Funds vs. Flexi-cap Funds (A category of Diversified Equity Funds) – Comparison of returns

Let us now compare the returns given by the top focused funds and flexi-cap funds which are a category of the Diversified Equity Funds.

Returns given by top 5 focused funds

(Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/focused-fund.html)

Note: The returns are as of 07 April 2022. The returns are for direct plans with growth options. The one-year returns are absolute, and the three and five-year returns are CAGR. The funds have been ranked based on five-year returns.

Returns given by top 5 Flexi-Cap (A category of Diversified funds)

(Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/flexi-cap-fund.html)

Note: The returns are as of 07 April 2022. The returns are for direct plans with growth options. The one-year returns are absolute, and the three and five-year returns are CAGR. The funds have been ranked based on five-year returns.

As seen in the above tables, flexi-cap funds have given slightly better returns than focused funds in the last five years. Also, flexi-cap funds have a more diversified portfolio than focused funds. As a result, flexi-cap funds are relatively less risky and volatile than focused funds.

What should you choose between a Focused Fund and a Diversified Fund?

An investor should divide their equity mutual fund portfolio into a core and a satellite portfolio. You can allocate 75-80% of your money to the core portfolio with diversified equity mutual fund schemes. You can allocate the remaining 20-25% of your money to a satellite portfolio with focused funds, sectoral funds, thematic funds, factor-based funds, etc. In this manner, you can manage appropriate asset allocation to diversified funds and focused funds.

Investing in mutual funds with the Glide Invest App

In the above section, we understood what focused and diversified funds are their returns and taxation. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate focused and diversified mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals. 

With Glide Invest, you will get guidance for:

1. A personalised risk profile assessment
2. Identifying your financial goals
3. Appropriate asset allocation
4. Making a financial plan for each goal
5. Automating the financial plan
6. Review and analysis of your financial plan 
7. Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App and get started.