Whalesbook
Investors are shifting their focus in equity funds, moving from chasing high returns in concentrated portfolios to evaluating the stability of diversified strategies. While focused funds delivered exceptional gains in 2023, a year later, many experienced sharper declines than their flexi-cap peers, showing the usual volatility of high-conviction bets.
The Volatility Spectrum
The recent market cycle has starkly highlighted the differing risk-reward profiles of focused and flexi-cap funds. In 2023, focused funds, with their limited number of high-conviction holdings, captured investor attention by delivering returns reaching up to 40%, far exceeding the 25% achieved by many flexi-cap funds. However, this concentration proved a double-edged sword. By early 2025, as markets faced pressure, several of these same focused funds saw drops nearly double that of their more diversified flexi-cap counterparts. This sharp reversal shows how a concentrated portfolio magnifies both upside potential and downside risk. SEBI's 2020 fund recategorization officially created these categories, setting up flexi-caps as adaptable, all-weather options and focused funds for aggressive growth. While average returns over three and five years remain closely matched, hovering around 14-17% according to various data providers, the journey to achieving these figures has been profoundly different, marked by significant swings and drawdowns that are critical for investors to assess.
Structural Divergence and Valuation
Behind similar average returns, these fund types have fundamental structural differences. Flexi-cap funds, mandated to hold at least 65% in equities, offer managers broad discretion across market capitalization and geographies. This includes strategies like international equity allocation to help manage domestic valuation risks. In contrast, focused funds operate under a strict cap of 30 stocks, forcing higher weightings per position, typically between 2% and 8%. This concentration means individual stock performance has a much larger impact on net asset value. On average, flexi-cap funds show a P/E ratio around 25, slightly lower than focused funds which tend to trade around a P/E of 28, indicating investors pay more for concentrated portfolios. Competitor funds in the broader diversified equity category generally trade at P/E ratios of 22-23. Historical performance during market downturns, such as the 2018 correction, showed that focused funds saw drawdowns about 2-4% deeper than flexi-cap funds, a pattern that has repeated in more recent volatile periods. Changes in the wider economy, such as shifts favoring value stocks over growth stocks, can also influence fund choices, potentially favouring the broader approach of flexi-caps in certain conditions.
Risk Metrics and Investor Temperament
Risk categories reflect these structural differences. Flexi-cap funds are generally considered moderate to moderately high risk, where diversification helps reduce the impact of single-stock underperformance. Focused equity funds are classified as high risk, as underperformance in even two or three key holdings can significantly impact the fund's net asset value. Data indicates that the standard deviation for an average focused fund (12.6%) is higher than that of an average flexi-cap fund (12.3%), confirming greater volatility in concentrated portfolios. Therefore, choosing between these fund types is less about chasing past returns and more about matching your comfort with market volatility and potential for sharper losses.
The Concentration Risk Premium
Focused funds aim for higher returns through strong stock picks, but this strategy inherently involves significant concentration risk. Unlike diversified flexi-cap funds, where a few underperforming stocks can be absorbed by stronger performers, a focused portfolio's performance depends heavily on fewer stocks. If these key stocks falter due to company issues or sector challenges, the impact on the fund's value can be severe and swift. Recent market data shows that HDFC Focused Fund aims for high conviction, but its performance has recently lagged its benchmark by approximately 3%, a reminder that concentrated bets don't always pay off. Furthermore, the strict 30-stock limit, a key SEBI mandate, may not offer enough buffer against unexpected stock issues, leaving investors more exposed to losses compared to the stronger diversification in flexi-cap funds.
Analyst View and Strategic Alignment
Analysts suggest focused funds can still generate high returns when their top stock picks succeed, but their volatility remains a key concern for many investors, especially in uncertain economic times. Recent reports note the higher risk of concentrated portfolios may not always be worth the reward for risk-averse investors. Markets can shift quickly, making it risky to pick a fund category just because it performed best last year. Instead, a forward-looking approach requires investors to deeply assess their own risk tolerance, investment horizon, and ability to withstand market fluctuations. The structural differences between flexi-cap and focused funds are significant. They represent distinct risk profiles that must match an investor's temperament for lasting success.