FundsIndia explains: What is portfolio concentration?

Portfolio concentration is a term you would have come across in our fund reviews. We would have said that a portfolio is diffused across stocks, or, that the top ten stocks of a portfolio make up a certain proportion of the total, or, that a fund holds few stocks. Why is portfolio concentration a factor we look at?

What does it mean?
Portfolio concentration looks at the share of the top holdings of a portfolio as a proportion to the total. A higher share indicates higher concentration. A lower share of the top few instruments indicates that a portfolio’s holding is diffused. There isn’t a strict definition of what level is high and low. Generally, if a fund’s top five or top ten securities make up about 45-50% (or more) of its portfolio, then it is concentrated. It’s a diffused portfolio when the top ten securities account for less than 40%.

Funds cannot go to any concentration extent they like. By SEBI regulations, an equity and debt fund cannot invest more than 10% of its portfolio in a single stock/ debt instrument. It can go up to 12% after trustee approval. Further, a debt fund cannot have more than 25% of its portfolio exposed to a single sector. A leeway of up to 15% above this limit is allowed for housing finance companies.

It’s not just in individual securities that portfolios can be concentrated. Funds that hold high weights to a particular sector are also concentrated. In equity funds, for example, individual sectors can make up over 30% of portfolios. Such funds generally hold several stocks within a concentrated sector.

Why is it important?
Concentration risk holds for both equity-oriented and debt-oriented funds. Concentration of a portfolio in a few stocks or instruments means that a fund is very dependent on those few instruments to deliver returns. While the fund would hold other securities, these would not help push returns much. Because of this dependency, if even a couple of those calls go sour, the hit on the fund’s returns can be severe. Why then would a fund hold a concentrated portfolio? Because the opposite can also happen. Those outsized bets can deliver outsized returns. Therefore, a concentrated strategy usually indicates a higher risk strategy.

The recent debacle with debt funds of Taurus was partly due to the 10%-plus share the papers had in the portfolio. On the other hand, in the 2016 JSPL fiasco, debt funds from Franklin AMC suffered lesser because the funds held less than 5% of their portfolio in those papers. For debt funds, it is also hard to liquidate holdings quickly, exacerbating the impact of a call gone wrong. A high concentration especially in credit opportunity funds is a sign that the portfolio is extremely risky. On the other hand, Debt funds following a duration strategy would have concentrated holdings, because they simply bet on price movement in government securities. It doesn’t matter whether they hold twenty different gilt securities with similar maturities or just a couple. The resultant price gain will be the same. Concentration here is therefore not a risk indicator.

On the equity side, concentration has the potential to work very well. There are always some stocks soaring far above the market. High holding in such stocks can lift returns well above the benchmark and category. A diffused portfolio would see higher gains offset by lower gains or losses in other stocks. A concentrated strategy also works well in flat markets, when only a few stocks rise and the rest trade within a limited range.

There are ‘focused’ equity funds that take concentrated bets, holding just about 25-30 stocks in total. These funds follow a very bottom-up approach, picking stocks that can consistently grow, regardless of the economic or industry health. This apart, there are also funds that hold a large number of stocks, but the top stock weights are high at 8-9% of the portfolio. Examples of these are funds such as HDFC Top 200, ICICI Prudential Focused Bluechip, or Franklin India Bluechip, which would have suffered at one point or another if their top stock choices turned out to be wrong.

For mid-cap and small-cap funds, an additional risk is the impact a fund has on a stock’s price. In many smaller stocks, the number of shares available for trading is limited. When a fund buys excessively into such stocks, it tends to influence prices. And when it tries to sell, it may not find enough buyers quickly. So if a fund holds a concentrated portfolio in such stocks, the effect of this impact cost on returns can be drastic. For this reason, and the general high-risk nature of the segment, most mid-cap and small-cap funds, normally adopt a diffused portfolio approach.

Whom does it suit?
Pure concentrated portfolios or focused funds are usually a bet on a fund manager’s conviction and ability to identify stocks/ debt instruments correctly. Equity funds with concentrated holdings can be volatile or suffer periods of underperformance. Where a call goes wrong, the time taken for a fund to reverse the call and regain its footing will take longer than a diffused fund. Therefore, such funds suit those with higher risk appetites. For other funds, portfolio concentration is one of the tools used in analysing performance. A higher share of top stocks on its own does not automatically mean that the fund is highly risky.

This article has been updated to expand upon suitability of concentrated strategies