Concentration Risk

Diversification is an important principle in portfolio management, helping investors spread risk across different assets.

However, when a large portion of a portfolio is invested in just a few securities, sectors, or themes, it may lead to concentration risk. For mutual fund investors, understanding this risk is important, as it can influence the overall risk profile of their investments.

In this blog, we’ll explain what concentration risk is, the types of concentration risk, the factors that contribute to it, and approaches investors may consider managing it prudently.

Table of contents

• What is concentration risk?
• Types of concentration risk
• Why concentration risk is important
• How investors can manage concentration risk
• Factors contributing to concentration risk

What is concentration risk?

Concentration risk refers to the vulnerability that arises when a portfolio has significant exposure to a limited number of securities, sectors, or asset classes. Poor performance in these concentrated holdings can disproportionately affect the overall portfolio, making it more susceptible to losses.

This applies across various dimensions: individual equities, debt instruments, sectors, geographic regions, or investment themes.

In mutual funds, concentration risk often occurs when a fund allocates a large portion of its corpus to a handful of stocks or focuses heavily on one sector. For example, a fund where the top 5–10 holdings account for 45–50% (or more) of its portfolio may be considered concentrated, while lower percentages indicate greater diversification.

Types of concentration risk

Concentration risk may manifest in several distinct forms across a portfolio:

• Name/single-security concentration: This occurs when a large portion of the portfolio is invested in one or a few individual stocks or bonds. For instance, if 15% of a fund's assets are allocated to a single company, any adverse development affecting that company may disproportionately impact the overall portfolio performance.
• Sector/thematic concentration: This arises when exposure is concentrated in one industry or investment theme, such as banking, energy, or information technology. Even if the portfolio holds multiple securities, concentration in a single sector increases vulnerability to sector-specific developments or economic changes.
• Geographic/country concentration: In the case of global or international funds, excessive exposure to one country or region introduces risk related to country-specific economic, regulatory, or political events. This type of concentration may amplify the impact of region-specific market movements on the portfolio.
• Issuer-type/credit concentration: In debt-oriented funds, significant exposure to certain types of issuers (such as corporate bonds or NBFCs) or a particular credit rating segment may increase credit risk if that segment experiences stress or downgrade.
• Asset class/strategy concentration: In multi-asset portfolios, allocating too heavily to one asset class (such as equity versus debt) or one investment strategy (such as large cap versus mid cap stocks) represents another form of concentration that may affect portfolio risk and return characteristics.

It is important to note that multiple types of concentration may overlap within a single portfolio. For example, a fund may hold numerous equity securities, but if many of them belong to the same sector or geographic region, the portfolio may still face significant concentration risk.

Read Also: Systematic Risk: Meaning, Types, Formula, and Example

Why concentration risk is important

• Amplified losses: Heavy exposure to specific holdings can magnify the impact of underperformance, while a diversified portfolio may cushion losses.
• Increased volatility: Concentrated portfolios are more sensitive to the performance of a few holdings, leading to larger swings in value.
• Hidden overlap across funds: Multiple mutual funds may have overlapping holdings, increasing exposure to the same stocks or sectors without investors realizing it.
• Manager-specific risk: High-conviction bets by fund managers make the portfolio dependent on their decisions, increasing risk if positions underperform.
• Liquidity constraints: Concentration in certain securities may make it harder to exit positions during market stress, potentially causing larger losses.
• Systemic concentration: Industry-level concentration in a few large fund houses or sectors can affect the broader market and investor portfolios.

How investors can manage concentration risk

While concentration risk cannot be eliminated entirely, investors can use the following strategies to manage it effectively:

• Diversify across holdings and asset classes: Ensure no single stock, sector, or theme dominates the portfolio by combining equity, debt, hybrid funds, and other asset classes.
• Set exposure limits: Establish guidelines for maximum allocation to individual holdings or sectors.
• Check for overlap: Analyse underlying holdings across multiple funds to avoid excessive exposure to the same stocks or sectors.
• Rebalance periodically: Adjust positions that have grown disproportionately over time to maintain diversification.
• Limit allocation to concentrated funds: Keep sectoral or thematic fund exposure to a reasonable percentage of the overall portfolio.
• Stay informed: Monitor sector developments, regulatory changes, and macroeconomic trends to make informed decisions.
• Seek professional guidance: Advisors can help assess diversification and suggest portfolio adjustments.

These steps can help investors reduce concentration risk while maintaining opportunities for potential returns.

Read Also: What are the types of risk in investing?

Factors contributing to concentration risk

Understanding the factors that may lead to concentration risk can help investors recognize and address it proactively. Key contributing factors include:

• High conviction in specific ideas: Fund managers or investors may allocate larger portions of their portfolio to ideas or opportunities they have strong belief in.
• Market trend following: When certain sectors or themes gain significant attention and experience strong performance, capital tends to flow disproportionately into those areas.
• Fund mandate constraints: Some mutual funds, such as sectoral or thematic funds, have mandates that inherently focus on specific areas of the market.
• Behavioural tendencies: Investors and fund managers may gravitate toward familiar or well-known names, leading to concentration in popular stocks or sectors.
• Fund size considerations: Very large funds may find it operationally challenging to maintain positions across numerous securities. As a result, such funds may concentrate holdings in fewer large cap stocks that offer sufficient liquidity to accommodate large transaction sizes.
• Common holdings across the industry: Many funds may hold similar high-conviction stocks, particularly among large cap names. This industry-wide pattern may create concentration at a macro level, even if individual funds appear diversified.

Conclusion

Concentration risk is a key consideration for mutual fund investors. While concentrated portfolios can offer higher potential returns, they also increase the likelihood of losses if specific holdings underperform. The right level of concentration depends on an investor’s risk tolerance, time horizon, and financial goals. By understanding the types of concentration risk, regularly reviewing portfolio holdings, and following disciplined diversification practices, investors can manage risk while keeping growth potential intact.

FAQs

What is concentration risk?

Concentration risk refers to the vulnerability that arises when a portfolio has excessive exposure to a limited number of holdings, such as specific stocks, sectors, or asset classes. When a portfolio is concentrated, poor performance in those specific exposures may significantly impact overall portfolio returns.

How is concentration risk measured?

Concentration risk may be measured through various metrics, including the percentage weight of the top 5 or top 10 holdings in a portfolio. More sophisticated measures include concentration ratios or the Herfindahl-Hirschman Index (HHI), which calculates the sum of squared weight shares across all holdings to quantify the degree of concentration

What are the types of concentration risk?

Key types of concentration risk include name or single-security concentration (excessive exposure to individual stocks or bonds), sector or thematic concentration (overexposure to specific industries or themes), geographic or country concentration (excessive allocation to particular regions), issuer-type or credit concentration (relevant for debt portfolios with significant exposure to certain issuer types), and asset class or strategy concentration (heavy allocation to one asset class or investment approach).

What are the consequences of concentration risk?

Potential consequences of concentration risk include potentially larger losses when concentrated holdings underperform, increased portfolio volatility, liquidity challenges during market downturns, hidden overlap exposure across multiple funds, and heightened dependence on a few holdings. Poor performance in a concentrated segment may disproportionately impact the overall portfolio value.

How can concentration risk be managed?

Investors may manage concentration risk by diversifying across holdings, sectors, and asset classes; setting exposure limits for individual positions; conducting look-through overlap analysis across all their fund holdings; rebalancing their portfolio periodically; limiting allocation to highly concentrated funds such as sectoral or thematic schemes; and seeking professional guidance or using portfolio analysis tools to monitor and manage their overall exposure levels

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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