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Understanding concentration risk in your portfolio mix..

05 Jan 2023

One of the primary purposes of investing is to achieve diversification. It is considered to be a measure of risk mitigation. The reasons are not far to seek. You cannot afford to put all your eggs in one basket. When you have too much riding on one sector, one theme or one set of variables then you run a unique kind of risk called concentration risk. Essentially, concentration risk is the risk that your portfolio returns may be imperilled because there is too much dependency on a set of factors or triggers.
Why you need to be cautious of concentration risk?
Concentration risk arises from too much exposure to a particular story, theme or sector. That means if the triggers work against you then the portfolio returns could be seriously impaired. Let us understand why this is important. Your investment journey normally starts off with a financial plan and typically each investment will be pegged to a long term goal. Let us assume that your mutual fund X is pegged to your retirement goal. You have conservatively assumed that your equity fund will generate 14% annualized returns which is a very reasonable assumption. But, instead of investing in a diversified fund you have invested in a sectoral fund with focus on the IT sector. With the Indian IT sector going through a major churn and global IT spending reducing, your IT fund portfolio could underperform. Each year your fund earns less than 14%, there is more ground to make up in the subsequent years. That is why you need to be so cautious of concentration risk.
There are broadly 4 types of concentration risk that you could be exposed to..
Risk of concentrated exposure to a sector..
This is normal in a sectoral fund. Let us assume that you are invested in an IT fund or in a pharma fund. Both these sectors are going through a major churn globally. Firstly, they are overly dependent on the US market and the pain is already visible. Secondly, cheaper competition is emerging for both these sectors. Thirdly, the future of these sectors is shifting structurally and it could take some years for the Indian companies to come up to global requirements. Most of the leading stocks in these sectors have underperformed sharply in the last 2 years despite the Nifty being at a new high. That is a very simple and basic form of concentration risk that you run. That is why from a long term planning perspective; a diversified fund is always more preferable compared to sectoral funds.
Risk of concentrated exposure to a particular theme..
Concentration risk not only arises from sectors but also from themes. There are thematic funds that are not based on particular sectors but on much broader themes. For example a Commodity Driven Fund could invest in companies that are into steel, aluminium, copper, zinc and even oil. The challenge here is two-fold. Firstly, commodities tend to following synchronized cycles and we normally find all these metal prices going up and going down at the same time. Secondly, commodities have very long cycles of 10 to 15 years. That means if the commodity cycle has entered a downtrend, then your commodity fund could underperform for over 10 years in succession, quite a risky situation for your portfolio.
Risk of concentrated exposure to macro triggers..
This is a different type of concentration risk. Let us take the example of a fund manager who is holding banks, NBFCS, autos and realty stocks that account for 70% of the portfolio. While these belong to different sectors, they are all vulnerable to interest rate movements. With the Fed likely to hike rates by 100 basis points in 2018, rate sensitive stocks could be negatively impacted. We have seen rate sensitive stocks consistently underperform when the interest rates move upwards. All the above sectors are rate sensitive. Similarly sectors like cement, steel and infrastructure have a high level of GDP elasticity. So if the GDP falters then all these sectors could underperform. That is something to be cautious about.
Concentration risk in debt portfolio..
Remember, concentration risk is not just a risk for equity funds but also for debt funds. There could be a concentration of long-dated securities in the debt fund. That could make the fund underperform in the event of a rise in interest rates because long dated securities are more vulnerable to interest rate movements. Similarly, if your corporate bonds are too exposed to a particular sector or theme then the default risk could be a distinct possibility. We have seen in the case of J P Morgan Fund where an excess concentration to the Amtek Auto group almost brought the fund to the brink of default.
Avoiding concentration risk is the key to long term risk management. When you are pegging your portfolios to your long term goals, be extra sure that you do not fall into the concentration trap!

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