Do focused funds give better returns than flexi-cap funds?

Flexi-cap and focused funds have the free will to make their choices and decisions. They can invest across companies of all sizes - be it small, mid or large-caps.

But if you are a pop psychologist, you'd know that determinism is not too far behind when discussing free will. It's a school of thought that argues free will is an illusion, and uncontrollable internal and external forces govern our choices and decisions.

That's the case with focused funds, too. While they can invest across the market pool, they are restricted by external forces (read: regulators) to own up to 30 company stocks only.

As a result, an average focused fund has just 29 stocks in its portfolio since the beginning of 2021, whereas a flexi-cap portfolio owns 51 stocks on average.

Given this portfolio restriction, we noticed a few more differences between the two sets of funds.

1. Diversification
Focused funds, constrained to a maximum of 30 stocks, inherently exhibit less diversification, leading to high concentration risk. This risk exposes the portfolio to greater volatility because an adverse movement of even one stock can potentially drag its portfolio returns.

2. Mid- and small-cap stance
Flexi-cap funds have a slightly higher small and mid-cap tilt.

That makes sense if you think about it. Since focused funds can hold just 30 stocks, they may be treading the small and mid-cap space more cautiously to mitigate risk.

What you also need to know is that focused funds must declare their investment bias upfront. For instance, three focused funds from LIC , Motilal Oswal and Quant had to mention that they have a large-cap bias. For this reason, we excluded the trio while comparing focused funds with their flexi-cap friends.

So, neither focused nor flexi-cap funds are more risky than the other. True, focused funds have a concentrated portfolio, but this risk is negated by having more affinity for large-cap stocks.

The better performer

There is a lazy assumption that focused funds give better returns because they run a tight ship of not more than 30 stocks.

(High concentration means high risk. High risk means high rewards. So goes the logic.)

But is that the case? Let's find out.

Category average returns
We compared the one-year returns of these funds from each day since January 1, 2014. This methodology checks their consistency, something point-to-point returns fail to indicate.

What we found was that an average flexi-cap fund and an average focused fund are in a dead heat. It's 50-50, meaning focused funds beat flexi-cap funds 50 per cent of the time, while the opposite is true as well.

Intra-house rivalry
Each mutual fund house can offer a flexi-cap fund and a focused fund. So, we conducted an in-house head-to-head comparison. The idea was that since each fund house has its own investment identity, the stock-selection process can be similar and, therefore, open to a fairer comparison.

Here, too, the fight between the two sets of funds is a close call, with 45 per cent of focused funds outperforming their in-house flexi-cap rivals based on one-year returns on a daily basis.

However, the dominance of flexi-cap funds comes to the fore when extending the evaluation to a five-year return on a daily basis. In this case, five of the seven fund houses saw the flexi-cap funds beating their focused peers.

Our take

The investment case leans towards flexi-cap funds when considering their five-year rolling returns since 2014.

But that aside, flexi-cap and focused funds showcase a near-even balance from a performance perspective, which is why our Analysts' Choice section has a curated list of flexi-cap and focused fund recommendations.

Also read: Flexi cap vs large cap: Which is better for the long term?