Concentration risk
Also written Concentration limits · Investment concentration · Single investee exposure · Concentration limit · Concentration risk (AIF limit)
The risk that a few positions are large enough, against the fund's capital, that one loss damages the whole portfolio — capped by SEBI at 25% of investable funds for Category I and II AIFs and 10% for Category III.
In plain language
Managers of AIFs follow a general policy of diversifying their investments. The workbook then adds the sentence that matters: the fund may at certain times hold only a few relatively large positions in relation to its capital, which means a loss in any one of them could have a material adverse impact on the fund.
That is concentration risk, and unlike most risks in the chapter it is not left to disclosure alone. SEBI puts a hard number on the largest single bet a fund may take.
How it works
The general investment conditions.
| Fund | Maximum in one investee company |
|---|---|
| Category I and Category II AIF | 25% of investable funds |
| Large value fund for accredited investors, Category I or II | 50% of investable funds |
| Category III AIF | 10% of investable funds |
| Large value fund for accredited investors, Category III | 20% of investable funds |
The limit bites directly or through investment in the units of other AIFs, so a fund cannot rebuild a concentrated position by routing it through a second fund. For investments in listed equity, a Category III AIF may compute the 10% against either investable funds or the net asset value of the scheme.
Investable funds is the base, and it is defined: the corpus of the scheme net of expenditure for administration and management of the fund, estimated for the tenure of the fund. It is therefore smaller than corpus, which makes the cap slightly tighter than it first looks.
Disclosure runs on two clocks. Concentration risk is one of the material risks an AIF must identify and report to investors, alongside foreign exchange, leverage, realisation, strategy, reputation and extra-financial risks. Under the Investor Charter, disclosure of material risks is made by Category I and II AIFs within 180 days from the year end, and by Category III AIFs within 60 days from the end of the quarter, or earlier if the fund documents say so.
Beyond the regulation, industry best practice asks the manager to fix, in the investment strategy itself, the maximum amount of each investment, the concentration restrictions, and the list of excluded sectors — and an investor conducting due diligence is expected to know the permissible concentration limits before committing.
A worked example
Chenab India Fund II, a Category II AIF, has a corpus of Rs 520 crore. Estimated administration and management expenditure over the tenure is Rs 20 crore, so investable funds are Rs 500 crore.
Single investee cap 25% x Rs 500 crore = Rs 125 crore
Largest holding, a logistics platform = Rs 120 crore (24% - compliant)
The logistics platform halves in value.
Loss Rs 60 crore
As a share of investable funds 12%
NAV falls from Rs 500 crore to Rs 440 crore
One name, inside the limit, costs the fund an eighth of its capital. Fourteen other holdings have to return 13.6% between them just to bring the fund back to where it started.
Now the same Rs 500 crore run three other ways:
| Fund | Cap | Largest single loss on a 50% fall |
|---|---|---|
| Category II | 25% — Rs 125 crore | Rs 62.5 crore, 12.5% of the fund |
| Category II large value fund | 50% — Rs 250 crore | Rs 125 crore, 25% of the fund |
| Category III | 10% — Rs 50 crore | Rs 25 crore, 5% of the fund |
| Category III large value fund | 20% — Rs 100 crore | Rs 50 crore, 10% of the fund |
The accredited-investor concession doubles the permitted concentration in every case. That is the regulator's judgement about who can be left to look after themselves, and it is exactly the kind of row an exam turns into a question.
Why NISM asks about it
Chapter 9 section 9.5 carries concentration risk with the 25% and 10% caps, Chapter 17 section 17.9 gives the general investment conditions including the large value fund concessions and the definition of investable funds, Chapter 6 section 6.8 lists concentration risk among the material risks an AIF must report, and the Investor Charter in Chapter 13 sets the reporting clocks. A numeric question on 25 versus 10 is close to certain.
Common exam traps
- 25% for Categories I and II, 10% for Category III. The smaller number belongs to the listed-markets category, which is counter-intuitive until you remember Category III trades.
- Large value funds for accredited investors get double — 50% and 20% respectively.
- The base is investable funds, corpus net of estimated administration and management expenditure — not corpus, and not NAV, except that Category III may use NAV for listed equity.
- Exposure through units of other AIFs counts. The cap cannot be sidestepped by investing through a second fund.
- Diversification is a policy, not a promise. The workbook explicitly allows that a fund may hold a few relatively large positions.
- Two reporting clocks: 180 days from year end for Category I and II, 60 days from quarter end for Category III.
Where this is taught
- Series XXI-B · Chapter 9: Portfolio Management Processintroduced here
- Series XIX-C · Chapter 9: Fee Structure and Fund Performanceintroduced here
- Series X-A · Chapter 15: Portfolio Construction Processintroduced here
- Series XXI-A · Chapter 9: Portfolio Management Processintroduced here
- Series XIX-D · Chapter 7: Fund Performance and Benchmarking of AIFsintroduced here
- Series XXI-B · Chapter 17: Risk
Related terms
- Net Asset ValueThe net assets of a mutual fund scheme divided by the number of units outstanding — what one unit of the scheme is worth on a given day, after every liability except the unitholders' own.
- Accredited InvestorAn investor certified by an accreditation agency as meeting SEBI's income or net-worth tests, and therefore allowed into products on relaxed terms — including below the Rs 1 crore AIF floor.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Private placement memorandumThe offer document of a Category III AIF, filed with SEBI through a merchant banker at least 30 days before a scheme launches — and the document SEBI comments on but never approves.
- Leverage riskThe risk that borrowing or derivative positions magnify a fund's losses — which is why SEBI caps Category III leverage at two times NAV and permits Category I and II almost none.
- Investor Due DiligenceThe investigation an investor runs on an AIF and its manager before committing capital — the process of investigation and evaluation into the details of a potential investment.
- Activist StrategyAn event-driven Category III AIF strategy that takes a significant stake in a company facing a material corporate event, aiming to improve its operations by participating in management.
- Investment constraintsLimits on the investments an investor can take exposure to — liquidity needs, time horizon, regulatory and tax constraints, exposure limits, and unique needs and preferences — recorded in the IPS.
- Sector rotationAn active, top-down equity strategy of shifting portfolio weight into sectors expected to benefit from the current phase of the economic cycle, and out of sectors expected to lag.
- Risk frameworkThe risk structure a portfolio manager sets at the strategic level, in line with the investment objective — it names the risks, ranks them, decides how each will be treated, and is monitored and modified continuously.
- Risk treatmentThe action a portfolio manager takes when a risk event occurs — tolerate it, mitigate it, transfer it, or terminate the activity — chosen on the nature, severity and frequency of the event.
- Thematic investingInvesting behind a significant opportunity or structural trend — such as electric vehicles — across its value chain, without starting from research on individual stocks, and spreading risk across uncorrelated themes.
- Fund of fundsAn AIF that invests in the units of other AIFs rather than directly in investee companies — buying diversification across managers and strategies, and paying two layers of fees for it.
- Downside riskThe probability of a loss on account of falling asset prices in changing market conditions — the half of volatility investors actually mind, measured by maximum drawdown and value at risk.
- Cross sectional diversificationHolding equities across different industries, sectors and geographies at a given time, so that sector- and company-specific risks offset. It cannot remove market risk.
- Highly concentrated portfolioA portfolio parked in just a couple of securities with no real diversification — the mirror-image mistake of over-diversifying across too many similar funds, and the one the Adviser must correct in the other direction.