Many of our readers share information of their mutual fund portfolios with us in the Post Your Queries section of our website. I have observed that, number of mutual fund schemes in the investor’s portfolio ranges from 3 or 4 to dozen or even more. I have across several mutual fund posts, where the bloggers have opined on how many funds you should have in your mutual fund portfolio. A common theme in almost all these posts, with which I am in full agreement, is that, adding more funds to your portfolio does not necessarily improve the risk diversification.
I have explained this concept a number of times in our blog. Mutual fund schemes themselves are a diversified portfolio of the stock. The aim of the fund manager is to diversify unsystematic (stock and sector specific) risks and take systematic (market) risk only. However, while fund managers reduce unsystematic risk, it is not entirely diversifiable(eliminated) because the fund manager wants to beat the benchmark. If you want to take only market risk, you should invest in an index fund. Some investors think that, by investing in a number of mutual fund schemes they would be able to achieve more diversification. While theoretically, unsystematic risk can be reduced by investing in different mutual fund schemes because they may have different stocks and sector weights, from a practical viewpoint, not much incremental diversification can be achieved by adding many funds to your portfolio. Let me explain, why?
Take a large cap oriented diversified equity fund. In current market conditions, you will find that the following sectors will have the highest weights in the fund portfolio – banking and finance, automobiles and auto ancillaries, cement, petroleum, technology / software, pharmaceuticals, FMCG, capital goods etc. Now take another large cap oriented diversified equity fund and you are likely to find that, the same sectors will figure prominently in this fund’s portfolio as well. The individual sector weights can be different, but their relative overweight / underweight positions versus the market benchmark index might be the same. This is because fund managers of both the schemes want to beat the index. Unless they have diametrically opposite views on which sector will outperform / underperform, the sectoral bets will not be dramatically different. So if you invest in both the funds, the diversification benefit to your overall portfolio will only be marginal.
A major benefit of mutual fund investing for retail investors is convenience. By having a lot of funds in your portfolio, you are not gaining much in terms of diversification, but you may be giving up convenience, because smaller number of funds is much easier to track and manage. Let me explain with the some examples. If you have 3 or 4 funds, you will know very easily if these funds are performing well or not and take necessary actions; if you have 20 funds in your portfolio, you will have to put in some effort to see, which funds are doing well and which funds are not. Secondly, unless you have an online portfolio viewer, where you diligently input information of all your mutual fund investments, you will have a hard time keeping track of all your investments.
Someone in my family had to spend nearly a month, simply to make a list of all the schemes / folios he invested in for the last 25 years. If you are investing over a long period of time, with multiple financial advisors / distributors, it can be hard to keep track of all your investments. Thirdly, if you are investing through SIPs in a many schemes, you will have to ensure sufficient balance in your bank accounts on every SIP auto-debit date. Finally, if there changes in your personal details like address, mobile number, email address, bank etc., you have to inform all the fund houses where you have investments with proper documentation, otherwise, you will not receive notifications or worse, have payments to you returned.
So far we have discussed, why having a large number of mutual fund schemes in your portfolio is not necessarily beneficial and in fact, can lead to inconvenience. Let us now discuss, how to decide the number of funds that you should have in your portfolio. In some websites / blogs, I have read that, 4 to 5 funds are good enough. Some people think that 7 to 10 funds are a good number. If you ask me, then I will say that, number of funds should depend on your investment objectives.
The most important part of investment process is determining the correct asset allocation. Asset allocation refers to the mix of different asset classes in your portfolio and it depends on your risk tolerance. Younger investors typically have high risk tolerance and should have the major part of their assets allocated to equities, while older investors (with lower risk tolerance) should have higher allocations to debt.
For the equity portion of your portfolio, diversified equity funds should form the core, as per expert financial planners. How many diversified equity funds should you invest in? As discussed earlier, a diversified equity fund aims to reduce risk by investing in a diversified portfolio of stocks across sectors and market segments; having many funds in your portfolio may not necessarily give a lot more diversification. You can, if you want, invest in just one good diversified equity fund. The returns of a diversified equity fund are driven by the performance of the fund manager, in addition to market returns, of course. If you have a large investment amount, then it is understandable that, you may not want to put all your eggs in the basket of one fund manager only. Investing in 2 to 3 diversified equity mutual fund schemes should suffice. However, you should note that, by investing in multiple schemes, you are not necessarily diversifying unsystematic risk; you are only diversifying fund managers.
For investors with higher risk appetite, investments in small and midcap market segments can provide a booster to returns over a long time horizon. If you have a high risk appetite, you can invest in small and midcap equity mutual funds. Again, you invest in just one good midcap fund or 2 to 3 (if you want to diversify fund managers). If you want to save taxes under Section 80C of Income Tax Act, then you can invest in Equity Linked Savings Schemes (ELSS). ELSS is one of the best tax saving options in India. You can follow the same diversification principles discussed above for ELSS funds as well.
Let us now come to the debt portion of your portfolio. From an asset allocation perspective, it is important that, you consider your entire investment portfolio (which may include products other than mutual funds) for the particular financial goal that you want to achieve. In our country, unfortunately, debt funds are not automatic preferred fixed income investment choices for retail investors. Be that as it may, when making investment decisions based on asset allocation, you should factor in your entire investment portfolio.
As far as debt funds are concerned, your investment objectives are very important. If you want stable income or if you have short (1 – 2 years) time horizon, then accrual based debt funds are the best choices. You should know that, performance of debt funds (especially accrual based funds) are much more predictable than equity funds and the outperformance / underperformance band versus the benchmark is much smaller; my point is, diversification benefits of multiple short term debt funds is much smaller than equity funds. So, selecting one good debt fund should be sufficient for your investment needs. Choice of a debt fund, as discussed earlier in my blog, should be informed by the Yield to Maturity (YTM) and Duration of the fund. Funds with higher YTM and same duration are likely to give higher returns. Therefore, you should research these two factors before investing. An important consideration for conservative debt fund investors, especially in light of some unfavourable news coming out of this sector over the past 2 years or so, is credit risk(mind you though, some investors may prefer limited credit risks to get higher yields). You should study the credit risk profile of the funds carefully and make sure that you are comfortable with it (high credit quality, if that is what you want) before investing. You should also study the historical performance of the funds, especially in terms of rolling returns. With regards to debt funds, good research before investing can be more beneficial than diversifying with multiple schemes. You should consult with your financial advisor.
If your debt investment objective is both capital appreciation and income, then you can invest in long duration funds. You should know that, long duration funds can be volatile in the short term, due to changes in interest rates. If you have a sufficiently long investment horizon, then long duration funds can outperform accrual based funds in a favourable (downward trajectory) interest rate environment. Therefore, in addition to accrual based funds, you can also add long duration funds in your portfolio.
If you do not have income needs in the short term and at the same time, unsure about future interest rate trajectory, then instead of choosing accrual based funds and / or long duration funds, you can invest in debt funds which have a flexible interest rate strategy; these funds are known as dynamic bond funds. These funds are more likely to give stable returns in different interest rates environments, though they may underperform accrual based funds in specific interest rate scenarios and long duration funds in other scenarios. In summary, your debt fund strategy and consequently, the number of debt funds you have in your portfolio, should be determined by your own investment goals.
Expert financial planners suggest that, you should have some money invested in very liquid and safe instruments for contingency needs. Most investors in India park their money in savings bank, but money market mutual funds can be excellent alternative liquid investment choices; the returns of money market mutual funds (liquid funds and ultra short term debt funds) are much higher than savings bank interest rate. It is always advisable to have a few months of your regular expenses, invested in money market mutual funds. Returns of money market mutual funds are quite predictable, if you keep a track of prevailing yields in the money market. Diversification benefits are very minimal. However, you should make sure that, the AUM of the money market fund that you are investing is sufficiently large and exposure to a single issuer is small.
Based on the considerations discussed in this blog post, you can determine how many mutual fund schemes you want to invest in. If we combine all the factors discussed, the number should not be large. In addition to the conventional mutual fund investment choices, investors may also want a portion of their asset allocation in gold; you may, in that case, invest in gold ETFs or gold funds. Some investors may also want some exposure to international markets; you can invest in international funds for that purpose. If you have sufficient knowledge of a sector or theme, you can also invest in thematic / sector funds. These investment options should not be your core investment strategy, but add-ons for specific needs (if any). An important theme in our blog, as some of our regular readers may have observed, is making your needs as an investor, the focal point of your investment strategy and not basing your investments on thumb rules masquerading as conventional rules of wisdoms. You should think about your investment objectives and consult with a financial advisor, to decide which and how many mutual fund schemes are suitable for you.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Dwaipayan leads content production and mutual fund research in Advisorkhoj.com. He is actively involved in business development strategy, driving revenue growth and profitability, delivering superior customer satisfaction and talent development in Advisorkhoj. An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with nearly 17 years of management and consulting experience in financial services domain across several geographies. In his previous corporate role, Dwaipayan was the Chief Financial Officer of American Express Global Business Services in India. He also co-founded a boutique consulting start-up to advice companies on business restructuring initiatives like private equity funding, mergers & acquisitions, divestitures, outsourcing and organizational restructuring. Dwaipayan has a strong track record of driving superior financial performance and developing talent in the organizations he has been involved with. He can be followed on his Twitter handle @DBadvisorkhoj.
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