The saying goes “Don’t put all your eggs in one basket” – with respect to investments and portfolio this means that one should diversify ones portfolio to spread their risk across stocks, fund managers, asset management companies (AMCs), corporate houses, sectors, market cap and asset classes. For investment in the stock market it is said that an individual should spread their risk across stocks, sectors, market caps, corporate houses etc. by investing in a minimum of 15 to20 stocks. However mutual fund investors tend to apply the same number to the quantity of schemes they own across mutual fund houses. A mutual fund portfolio should be concentrated to a maximum of 7 to 10 schemes.
The basic idea behind investing in a mutual fund is to enjoy the benefit of investing small amounts in a portfolio managed by a professional fund manager. This manager has the aptitude and capability to manage your funds in such a fashion that would ideally give you returns higher than the market return. A mutual fund scheme by nature is diversified and thus it is meant to diversify unsystematic risks, i.e. company specific risk and sector specific risks. If we have a look at the portfolio of a diversified mutual fund scheme i.e. not a thematic or sector specific fund; we realize that these funds are diversified in most of the aspects. We take an example of one of the most popular Balanced Fund “Fund A” as on 31 March 2016 it had assets under management (AUM)@ of Rs. 7,773 Crores in 77 stocks, 7 debt papers, 13 sovereign Government of India papers and money market instruments under its portfolio across 26 sectors and all market capitalisation segments. If each fund has this level of degree of diversification then the requirement for several funds in your portfolio to obtain diversification is a pointless exercise.
Diversification is a prudent exercise nevertheless over diversification is damaging on account of the following reasons
No additional dilution of risk
The three main objective of diversification are as follows:
- Reduction in risk
- Higher return
- Stability in performance
If all the three objectives are achieved by investing in lesser schemes than adding further schemes becomes a pointless exercise. In a study conducted by Morningstar it was concluded that addition of any number of schemes after seven was a futile exercise. It was noted that the risk of a portfolio measured by standard deviation did not decrease significantly for any scheme addition post the seventh.
Too many cooks spoil the broth
“Resource Curse” or in modern terminology “problem of the plenty” or as the saying goes “too many cooks spoil the broth”. Similar to the fact that a securities portfolio of over 20 stocks becomes difficult to track for results, dividend, bonus, split etc. and a mutual fund portfolio of over 7 to 10 schemes becomes strenuous to track for changes in fund manager, investment objective, expense ratio, dividend, etc. It is also difficult to monitor and track the performance of a large number of schemes on ongoing basis. Outstanding performance by one particular mutual fund scheme in your portfolio may mask underperformance by other schemes, and you may continue to hold the underperforming schemes for a long period of time. On the other hand, if you had fewer schemes in your portfolio, you can easily spot underperformance and take appropriate actions.
Dilution of impact of the performers
Having too many mutual fund schemes takes away the slice of cake from your portfolio. The negative impact of under-performing fund overshadows the one of the outperforming ones. As noticed in “Fund A” the fund has less than 1% exposure to each of the 60 securities in its portfolio which comprises of 26.97% of the total portfolio valuation. If a stock say “Stock X” having exposure of 0.04% of the fund portfolio climbs up by 10% during a day, assuming the others have remained stagnant, the NAV would rise by mere 0.40%. On the contrary if the stock prices plummeted the impact would be insignificant. Outstanding performance by one particular mutual fund scheme in your portfolio may mask underperformance by other schemes, and you may continue to hold the underperforming schemes for a long period of time. On the other hand, if you had fewer schemes in your portfolio, you can easily spot underperformance and take appropriate actions.
Increased probability of overlapping
A diversified equity mutual fund usually have about 40-60 stocks in their portfolio. Virtually similar stock is owned and almost the same percentage of exposure exist to a particular sector, leaving the investors wrongly presume that they have diversified their portfolio. Thus, as we keep on adding more funds to our portfolio there is a lot of overlapping and repetition, defeating the whole purpose of diversification.
You may think that it’s quite a strenuous task to check overlapping in your mutual fund portfolio, however presently there are tools on websites which would give us some idea with respect to this. The 2 tables below shows a set of 2 funds; where Table 1 shows negligible overlapping of stocks while Table 2 shows high degree of duplication between funds of the same category.
Valueresearchonline has a tab titled “Who owns what”, if you type the security name, the tool downloads the list of all funds who own the stock and in what quantity. The tool also mentions what is the percentage of the security in the fund valuation.
How to avoid duplication
Avoid investing in multiple schemes of same type managed by the same Fund Managers:
Avoid purchasing multiple funds in the same category managed by the same fund manager. Fund managers have the tendency to purchase the stocks of the same company for most of the funds managed by them. A thumb rule suggests that you should have maximum exposure of 10% - 15% to funds managed by a fund manager.
Avoid purchasing a large number of schemes of same fund category:
There are basically 5 types / category of Equity Oriented Mutual Funds.
- Balanced Fund (Hybrid Equity Oriented)
- Large Cap Funds
- Equity diversified / Multicap / Flexicap Funds
- Small & Mid Cap Funds
- Equity linked saving scheme (ELSS) Funds
Selecting a large number of funds of the same category does not necessarily improve portfolio diversification. A couple of funds from each category can sufficiently fulfil your portfolio diversification objectives.
You may also like to check the Top Performing Mutual Fund Schemes in these categories
A mix of growth and value funds improves diversification
There two investment styles – Growth and Value. Growth investment style focuses on companies which grow their revenue, earnings, cash flow, at a faster rate than the industry while value investment style involves picking up stocks whose price does not represent the fundamental valuation of the company (in other words undervalued stocks). Just as small cap securities operate differently than large cap securities, value stocks act in a different way from growth stocks. Growth stocks usually give higher returns in near to medium term than value funds, because it may take long time for the value potential of a stock to be unlocked for a variety of factors. But over a sufficiently long investment horizon, value stocks can give outstanding returns. While value stocks can be found across all market cap segments, a large number of them are in the small and midcap segment. When constructing a portfolio one should select a mix market segments and investing styles to achieve best portfolio returns in the long term. Avoid overlapping market segment and investment style mixes. For more detailed analysis one could use the “Morningstar Style Box Approach”. This methodology helps an investor to keep overlapping to the minimal by using the value and growth investing theory.
Administer ones sectoral exposure:
It has been noticed presently that most of the funds have maximum exposure to the banking and financial services (BFSI) sector. If the fund you have chosen has maximum exposure to the banking sector we would advice you to choose a fund which is tilted towards any other sector other than banking. Usually if two funds have the similar weightage towards a sector, has similar exposure towards particular stocks too.
To determine the exact amount of overlap is a laborious task, for this one has to maintain an excel worksheet with the list of all stocks held in each of the funds. The investor could enjoy the benefit of “Portfolio X Ray” tool from Morningstar which would help one analyse the complete portfolio with the percentage exposure to a particular sectorand a company.
As far as average retail investors in India are concerned there are four basic asset classes – domestic equity or mutual funds, fixed income, gold and real estate. Investment in an asset class is determined by the risk appetite of the investor, age of the investor, the investment objectives or financial goals, duration of investment, etc. If it is a long term goal (over 3 years) such as retirement planning for a young investor, then he could invest in equity oriented instruments. 5 to 6 equity large cap, diversified, mid and small cap fund could meet the purpose. If it’s a young investor having a short term financial goal of a vacation or accumulation of down payment for a purchasing a car then one should keep in mind that short period of 1 to 3 years requires investment in debt instruments such as corporate bonds. 2 to 3 short to medium term debt funds would suffice. If the investor has a goal of a marriage then partial funds could be invested in Gold ETFs. One gold fund would be sufficient.The remaining could be invested in debt or equity fund depending on the risk appetite and investment horizon.
To know what type of funds you should have in your portfolio based on your risk taking profile, you may like to check this Asset Allocation calculator
The number of funds that an investor should have in its portfolio is quite a subjective question and the answer varies from each advisor, however all of them manifest the same ideology of keeping the number to the minimal.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.