How does an active fund manager formulate strategy and allocate towards sectors? Arnav Pandya explains

Arnav Pandya, Founder, Moneyeduschool, says “whenever an active fund manager is managing a portfolio, the benchmark is an important component which will come into play. One has to see that within a particular fund how much is the variation the fund manager goes for from the benchmark in trying to earn that extra alpha or generate higher returns.”


The five sectors namely are financial services, consumer discretionaries, IT, healthcare and industrials. Talking about the exposure, the highest, 31% in financial services, consumer is 10%, IT 9% and health and industrial almost 6%. A lot of similarity is seen when an active fund manager frames his strategy for a particular fund which resembles the index or a benchmark. Do you think it is a very common practice or that is how it is supposed to be?
Whenever an active fund manager is managing a portfolio, the benchmark is an important component which will come into play because while the fund manager is trying to beat the benchmark because of the manner in which each of the funds are categorized by the definition of which has been laid down by the Securities and Exchange Board of India (SEBI) plus the fact that we are likely to have the main holdings, which are also part of the benchmark.

The portfolios in terms of weightages are not very different from what the benchmark is trying to say. For example, when one looks at the overall exposure in the market, financial services companies have the largest weightage in the BSE 500. They are nearly one third of the BSE 500 in terms of weightage by market cap. Fund managers also have got 31% of their total amount of assets under management invested in this area.

So one has to see that within a particular fund how much is the variation the fund manager goes for from the benchmark in trying to earn that extra alpha or generate higher returns.

Let us talk more about active strategies. In terms of equity fund managers following the benchmark in order to frame their own strategy, the kind of resemblance that has been seen, is it something that is usually done or is it because of the market condition that we are witnessing right now, itis something that the data is showing?
Fund managers will add good strong fundamental companies which are in line with their investment philosophies into the portfolio. Now it is quite likely that many fund managers end up with similar companies for a similar kind of fund. For example, if you see largecap funds, you will find that many of the top 10 holdings are similar across a wide range of actively managed largecap funds. The differentiator here is the kind of weightage that the fund manager is giving to each of these holdings because the weightage will determine the kind of outperformance or the underperformance that the fund is doing.

For example, if a fund manager is slightly more aggressive, it might go up to 8-9% in terms of the weightage to the top holdings in the portfolio. Someone who is more conservative will stop at 5 or 6%. Similarly, it is just not the same companies which are there in the portfolio which matters, but rather how much has been allocated to them. That also will play a role in the kind of performance of the fund. That is why you might see that even though funds in a particular category are within a range, some have outperformed and some which are lower than what the average would be seen in the category.

This particular diversification is usually for a largecap fund or maybe a flexi-cap fund?
If you look at the range of diversification, you will find this diversification across most categories of funds. So flexi-cap funds, multi-cap funds, midcaps, smallcap, all will have a large number of holdings which are adequately diversified. Now, one exception here would be the focus funds where the mandate itself says that the portfolio should not have more than 30 companies. So the fund manager will have concentrated bets which are there in the portfolio. But overall, in terms of diversification, you will find that most fund schemes, especially in the active sector, will have this kind of diversification.

Again, some categories might not be as diverse as others. Like I said, in focus funds, you might have sector funds which are not adequately diversified even in terms of the number of holdings within that. So that needs to be taken into consideration.

Looking at the kind of diversification, what could be the strategy to mitigate risk?
There are two things that fund managers do in this kind of situation. One is that having a large number of holdings by itself ensures that there is mitigation or reduction in terms of risk. The second is also what I mentioned earlier, which is that if they want to play it safe or rather reduce the risk even further, they will not allocate too much to the top holdings, which means that even if, say, the top holdings are in the range of 4% to 5% in terms of weightage in the portfolio, just outperformance or underperformance by one or two top holdings will still not have a big impact in terms of the overall situation for the fund.

These are the ways in which fund managers try and ensure that even by the very basic feature of having multiple holdings, they are diversifying, they are still trying to reduce the risk further, specifically in categories which are more volatile like midcaps, smallcaps and where having a lesser number of holdings can lead to huge amount of volatility within the portfolio.

Let us talk about normal diversification that you see across funds, maybe we can pick up large, mid and small. And talking about large-caps now, since we are seeing them back in favour, how is the diversification and allocation strategy adopted by fund managers normally?
What you will normally find is that, sectors which have a bigger weightage in the index and that is being tracked, like for example, you will find that no matter where you go, the financial services sector will have the highest weight, followed by consumer discretionary and IT, where the weightage is, say, one-third of that of the financial.

But one has to look at one more point – what is included under a particular categorization is also important because even though you might think that financial services are such a high weightage, financial services is not just a single type of company because you will find banks, insurance companies, asset management companies, non-banking financial companies, all of them come under financial services. And within each of them, the fund manager is also taking a call in terms of how much allocation is being done within even these kinds of sub-sectors.

For example, when you look at banks, the question there is should they go in for public sector banks or private sector banks? Even within, say, the public sector and the private sector space, how much is being allocated to the largecap banks and how much is going towards the midcap banks? All these are factors which ensure that even though on an overall level, you might think that the number of holdings or in terms of sectors are less but actually there is diversification within the sector, within the sub-sector and even in terms of market cap, which is going on when the fund manager is making the decision.