Stay away from concentration risk

Knowledgeable investors may take concentrated bets, while others should remain diversified

When investing in stock markets, investors should be mindful of concentration risk, and try to protect themselves against it by diversifying their bets. This risk could arise from having too large a portion of your portfolio in one or very few stocks.

It could also arise from investing in stocks that are dependent on a single source of earnings, as recent developments at Noida Toll Bridge Company demonstrate. In mutual funds, concentration risk arises in funds that have very few (25 or less) stocks in their portfolios. Noida Toll Bridge, an IL&FS promoted company, built and delivered the DND Flyway in 2001. According to the terms of its build-own-operate and transfer (BOOT) contract, it had to transfer the bridge back to Noida Authority after 30 years. On October 26, the Allahabad High Court, responding to a public interest litigation (PIL) filed by the Federation of Noida Residents Welfare Associations, ruled that the company can no longer levy a user fee from vehicles using the flyway, as it has already recovered the cost of the project and reasonable returns. If the Supreme Court upholds the High Court's judgement on November 6, the company's business could come to a standstill as it derives its revenue largely from toll charges. Since the court judgement, the company's market cap has eroded by around 31 per cent.

Says Sanjiv Bhasin, executive vice president, IIFL: “Investors should have been cognisant of the risk of investing in a company that had just one project.” He further added that investors have to be wary about making equity investments in public-private partnership projects (PPP) in infrastructure, where debt levels tend to be high. The promoters depend on their ability to raise tariffs to be able to earn a return, but this is often not possible due to resistance from the public.

Given these risks, investors should avoid investing in stocks where the revenue comes from a single source. They should also build adequately diversified portfolios, so that even if one stock is hit by an event risk, the impact on the portfolio is limited.

Concentration risk also exists in mutual funds that run concentrated portfolios. The advantage of a concentrated investment approach is that fund managers can take meaningful exposures to their best stock ideas, which can result in outsized returns, especially in bull markets. In the large-cap space, funds like Axis Focused 25, ICICI Pru Select Large Cap and Motilal Oswal MOSt Focused 25 have done well by adopting a concentrated approach.  

Concentrated funds, however, also carry higher risk than their more diversified peers. “Since each stock position is fairly large, a few wrong calls, or calls that take time to perform, can lead to increased volatility or poor performance. In bear markets these funds can also decline more than their diversified peers,” says Kaustubh Belapurkar, director, manager research, Morningstar Investment Advisor India.

Given the high level of risk in these funds, experts suggest that only seasoned investors should invest in them. “Your most important criteria when choosing a concentrated fund should be the fund manager's track record in managing such a strategy, and the quality and strength of the research produced by the fund house's internal research team,” says Belapurkar. Investors should also have a longer investment horizon when investing in them, since they are prone to be volatile and can also underperform in the short term.