Having multiple options to invest in is a boon for risk averse investors. We all know diversification is good, as it helps us to spread our investment portfolio across asset class; or you can say we are minimising our risk by not being concentrated to one single avenue. So even we recommend diversification across asset class when it comes to investing.

 

One of the investment avenue we are focused on is mutual funds – a heaven for diversification. Mutual fund products are created with an objective of providing capital appreciation over a period of time by investing in an identified asset class or diversifying their portfolio across instruments in the asset class.

 

Too many mutual funds lead to over diversification

Mutual fund portfolios typically get built based on variety of inputs coming from media, websites, friends, family, colleagues and advisors actively selling NFOs. But, over a period of time, the list becomes bulky, and then ends up with a list of funds which look similar in terms of their style, portfolios and even fund houses.

 

At PersonalFN we have often come across portfolios of mutual fund investors and not to our surprise most of them make the same mistake – Over Diversification! Simply put they tend to diversify their holdings in 20-30 different mutual fund schemes and some times even more.

 

Well diversification is not the mistake. It is diversifying in multiple schemes having similar style and objective is definitely a mistake!

 

Know where your mutual funds are investing

You may wonder so what… but just to your notice, the top 20 holdings of most of the fund managers having focus towards a particular market cap or having similar objective, do concentrate towards same set of stocks in their investment portfolio.

 

As of December 2010, the total number of equity and hybrid mutual fund schemes investing in equities stood at 536, while total number of stocks that mutual funds invested in stood at 913.

 

Equity exposure of domestic mutual funds

	No. of Stocks	Corpus (Rs in Cr)	% of total Equity AUM of MFs
Total Equity Exposure – MFs	913	2,12,560.58	100.00
Exposure in top 10 Stocks held by MFs	10	57,917.99	27.25
Exposure in top 50 Stocks held by MFs	50	1,22,745.90	57.75
Exposure in top 100 Stocks held by MFs	100	1,54,900.94	72.87
Exposure in BSE Sensex stocks by MFs	30	86,081.11	40.50
Exposure in S&P CNX Nifty stocks by MFs	50	1,05,241.27	49.51

(As of December 31, 2010)
(Source: ACE MF, PersonalFN Research)

 

• Of the 913 companies that domestic mutual funds had invested in December 2010, the top 10 stocks constituted of 27.25% of the total equity AUM
• About 57.75% of the underlying investments of mutual funds were in the top 50 stocks held by mutual funds
• 40.50% of the mutual funds equity exposure was in BSE Sensex stocks, while 49.51% was in S&P CNX Nifty stocks
• While 50% of the total equity AUM of domestic mutual funds were invested in only 34 stocks

 

Such a concentration towards same set of stocks may in turn increase your concentration towards some particular stocks.

 

Hence if you continue to invest in multiple schemes having similar objective, investment style and investment universe (i.e. market cap segment), the chances are you may end up with major allocation of your portfolio in same set of stocks.

 

So you may ask - what’s the right way?

Diversify your risk across investment styles to create long term wealth

While building a mutual fund portfolio, most investors do forget their basic objective of investing in mutual funds i.e. long term wealth creation.

 

Investors vie for "best return" scheme, the flavour of the month/year, hot NFOs (as they are excitingly priced at Rs 10), the sunrise sector/ infrastructure funds, which make them find place in the portfolio. Also not to mention the constant churning that followed, with one fund moving out and another entering in. This hectic pace of activity leaves investors with tons of schemes, most of them looking the same.

 

We always advise to – first identify your risk appetite as well as investment time horizon and accordingly allocate your portfolio across asset class and investment style that will help you diversify your risk across market cycles and in turn help you meet your long term goals.

 

Considering the investment universe and the investment styles followed by mutual funds, we have identified various category of mutual funds like diversified equity mutual funds focusing on various market caps (large cap, predominant large cap, mid cap, mid-small and micro cap, flexi cap) and styles (opportunities, value) also specialty funds like index, ELSS or thematic funds focusing on specified sectors. Other categories of funds are hybrid – equity oriented (balanced), hybrid – debt oriented (MIPs), debt/income, liquid, floating, gilt, Fund of Funds, Gold Equity FoF, Gold ETF and so on.

 

Indicative portfolio category allocation based on risk appetite

	Aggressive	Moderate	Conservative
Large Cap	Medium	High	High
Mid Cap	High	Low	-
Flexi Cap	Medium	Medium	-
Opportunities	High	-	-
Value	-	Medium	Medium
Balanced	-	Medium	High
Thematic	Low	-	-
Gold ETFs	Very Low	Low	Medium

(Source: PersonalFN Research)

 

You need not hold 5-10 schemes from each category; only 1 or 2 consistent schemes will do the job of long term wealth creation.

 

Holding too many funds with similar objective is a bad idea

Without identifying the funds objective, many investors keep on adding funds that have become star performer in the booming days, thinking that apart from diversifying their risk these funds will add extra returns in their portfolio. Investors do forget that after every boom, there is a gloom when these stars loose their shine.

 

Do remember that during mid cap rally, all mid cap funds (having similar objective and style) top the list and star rankings, while after downfall they lag the list and star rankings. Moreover, you may not be lucky enough to add mid cap funds before the rally start, and you may have become heavyweight on them only when the mid cap rally is almost reaching exhaustion points (almost over) and thus volatility starts knocking the doors of your portfolio. This increases the risk of your portfolio, as the major portion of your portfolio constitutes of mid cap funds.

 

Remember, while mutual funds are attractive investments because they provide exposure to a number of stocks in a single investment vehicle; holding too much of a similar objective funds can be a bad idea.

 

Many investors have the erroneous view that risk is proportionately reduced with each additional scheme in their portfolio. You need to understand that you can only reduce your risk to a certain point after which there is no further benefit from diversification.

 

Moreover, as the fund managers might be investing in same stocks or sectors, your continued investment in multiple schemes with similar objective, investment style and investment universe (i.e. market cap segment) may lead to overlapping of same underlying stocks, sectors or assets in your portfolio and in turn lead to addition of risk into your portfolio. Also if the underlying stocks or sectors start witnessing a dive, your over-diversification would not do any good to your portfolio.

 

Also every additional fund in your portfolio may add to the cost in terms of high expense ratio as well as multiple transaction cost. And any bad pick in your portfolio can lead to slowdown in performance of your overall portfolio. Thus the end result of all this will lead to increase in expenses, but reduction in portfolio performance.

 

And in the bargain the time which you would spend monitoring the large number of mutual fund schemes and thus the paperwork involved, will be futile.

 

So, how many schemes should one hold?

Number of funds you should ideally hold in your portfolio

Although there are number of mutual funds providing thousands of schemes to invest in, truly speaking there is no magical number that is right and will help you build an optimal portfolio. Just remember you don’t need to have dozen of schemes in your portfolio to diversify your risk, even a single diversified equity fund can diversify you risk in “n” number of stocks or multiple sectors. But you should note that they may lack the other styles on offer.

 

The magic lies in choosing the right fund (maximum 1 or 2 of each style) with a well established track record, sticking to its investment mandate, maintaining consistency in performance and most importantly it should be suitable for you as per your risk appetite and time horizon and help you meet your long term goals.

 

If you desire to build an ideal portfolio of mutual funds, then –

 

• You should look at holding funds that have different characteristics and behave differently
• You should also try to limit the number of funds in your portfolio and feel comfortable with your holdings
• And above all you should consider your investment objectives and goals. If generating regular income is your primary goal, then mid cap or sector fund may not fit your portfolio; while if your objective is capital preservation, then equity funds will not suit you.

 

Portfolio rebalancing is the key

More the number of schemes you hold – more complicated your portfolio becomes. Often people don’t know what to do with their mutual fund portfolio and how to rebalance them, as they are not sure what their actual holdings represent. Hence

 

• If you hold an existing portfolio then it is advisable to study and compare the category and the underlying investments in your portfolio.
• If you find significant overlapping of similar stocks or sectors, then it makes sense to eliminate some of those funds from your portfolio.
• If any of the funds are not matching your investment goals or have similar mandate (say 3-4 large cap funds and 2-3 mid cap funds), then it makes sense to exit and invest in a single fund having more consistent track record in their respective category.

 

Having a well diversified portfolio is good, but having it in right quantity is very important. You need to periodically review and rebalance your portfolio in order to eliminate overlapping and create wealth in the long term.

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Comments
amitacharya20012002@yahoo.co.in Jan 06, 2011 Very good article. Kudos for the same. Really this type of article & advice becomes a guide for the insvestor.
srijantrading@gmail.com Jan 07, 2011  I really do not understand this particular logic for SIP investor. I am planning to invest only in midcap funds, SIP. For SIP investing, when fund goes down it is an opportunity. Continue SIP till the time NAV of fund goes to high level. 3 years, 5 years or 8 years if required. Only problem is fund should perform well in good time. Midcap having higher beta, good for SIP. One fund may do the job but better diversify. Secondly, unlike Largecap, the number of stocks are very large in midcap. How all funds will have same/similar stocks in kitty?
nirmala.pillai00@gmail.com Jan 08, 2011 I have five Mf holdings through Sip of  total 10000Rs per mth 1-Hdfc prudence balanced growth 2-Hdfc top 200 growth 3-Dspbr T.IG.E.Rgrowth 4-Icici index retail growth 5-Icici prudential discovery growth I plan to invest for 10 years for a cumulative post retirement gain.are these funds o.k?regards
anilkumar.kapila@gmail.com Jan 12, 2011 Most of the advisers give this advice but the problem is that no one gives the actual number of Mutual Funds one should hold.Some specify only three to four funds in all while others specify eight to ten.

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