There are many people who have been taking advantage of volatile markets and putting their money in mutual funds. This shows that people are interested in investing in mutual funds, but most of the time, it is seen that investors end up having an unnecessarily large number of schemes in their portfolios.
This is a problem that many investors face. Investors end up having too much funds, in the name of diversification. Most miss the point that diversification is not about having as many funds as possible. Experts say that while diversification is important to any investment portfolio, having too many funds could be useless. After a certain point, you cannot get additional diversification benefits by investing in more funds.
But this is a problem that many investors face. In most cases, they end up having an unnecessarily large number of schemes in their wallets. Unfortunately, having too much funds is generally due to the sellers’ momentum. But sometimes, it’s due to investors’ own ideas about diversification.
Wrong way to diversify
While diversification is important to any investment portfolio, owning too many funds is useless. Diversification is not about having as many funds as possible. In fact, there are no additional diversification benefits available by investing in more funds beyond a certain point. There is always an adequate amount of diversification. And if it has more, that is, on diversification, it doesn’t help. Most investors can do it by having only a small number of funds of different types (of different categories).
Let’s take an example. Suppose an investor has four large-cap funds. Now, a large-cap fund, by definition (and SEBI’s categorization rules), needs to invest 80 percent of its portfolio in large-cap companies (defined as the Top 100 Companies by Market Cap). Therefore, the four large-cap funds will invest from roughly the same set of 100 companies. These four funds in one category (large cap) would simply mirror each other’s portfolios (to a large extent). And this leads to duplication. Having a large amount of similar funds only increases the portfolio. The investor will get no further diversification by investing in these many large cap funds.
Another aspect is that the portfolio of four large-cap funds will only yield returns that a large-cap index produces. If that’s the case, then there is no point in investing in active funds. Instead, you can simply choose a large-cap index fund. It will be cheaper and easier to manage too.
Exploring fund categories
In the example above, it would have been better for the investor to diversify investments across fund categories. In this way, the good performance of one category can compensate for the poor performance of another category.
Time and again I have heard that many investors (who already have too many funds) have a mistaken opinion that risk is continually reduced with each additional scheme they buy for their portfolios. But that is not the case actually. It can only reduce risk to a certain extent, after which there are no additional benefits of further diversification.
How many mutual funds are enough for you?
Like all things in personal finance, even this does not. Different investors would need different approaches. But in general, having 1-2 schemes in the chosen background category would suffice. That is, assuming you don’t have too many fund categories in your portfolio.
In equity funds, when you add more funds beyond a few, you’re basically adding more stocks in your underlying portfolio that might be identical to what you already have through existing funds. But on the other hand, it makes sense to aggressively diversify into debt funds. Even if that means being a little more diversified.
If you have too many funds in your portfolio, check your mutual fund portfolio and do the cleaning exercise to reduce clutter. If you cannot do it on your own, enlist the help of your investment advisor. Having a scattered MF portfolio does not adequately serve its purpose. The cleanup will require you to come out of certain funds and will have a capital gains tax. It is important to systematically cut the number of funds over a period of a few months so that the impact of taxes and exit charges can be minimized.