Here is Why Holding Too Many Similar Mutual Funds Can Drag Your Portfolio Returns

Feb 02, 2024 / Reading Time: Approx. 7 mins

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Here is Why Holding Too Many Similar Mutual Funds Can Drag Your Portfolio Returns

Diversification, as you may know, is the cornerstone of successful investing. A well-diversified portfolio of mutual funds allows investors to minimise the risk to their portfolio and earn optimal risk-adjusted returns.

But what exactly is meant by a well-diversified portfolio?

Many investors often question whether they are holding the right number of mutual funds in their portfolio to achieve their financial goals. The general assumption amongst investors is that if they keep adding popular, star-rated funds to the portfolio or newly launched funds, their portfolio will be well-diversified and in a better position to deal with market volatility. By doing so, investors often end up accumulating 15-20 mutual funds or more in their portfolio.

So, is it a good idea to keep adding new mutual fund schemes to the investment portfolio to earn better returns and minimise the risk?

Well, the answer is no because as the saying goes "Too much of anything is good for nothing". In other words, investors should avoid over-diversification of the portfolio.

Read on to know why investors should avoid adding too many similar mutual funds in their portfolio:

Adding too many similar schemes in the portfolio leads to over-diversification, which is counter-productive to creating wealth. When one holds a plethora of similar categories of mutual fund schemes, it can cause more harm than good.

Surely, it will provide you with a little bit of everything (help diversify), but not enough of anything (optimally diversify). This is because mutual fund schemes within a category hold more or less the same set of stocks in their portfolio. So, when an investor invests in two or more schemes within a category, it is likely that they have invested in the same stocks, albeit in varying exposures in their portfolio. This results in mutual fund overlap.

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Holding too many similar schemes can expose the portfolio to concentration risk leading to polarised returns as it will be skewed towards a few set of stocks, sectors, market cap, or investment styles.

As a result, while it gives the impression of diversification, it may not help achieve the intended objective i.e. minimise the risk during volatile market conditions, and earn better risk-adjusted returns in the long run.

To achieve, the intended objective as highlighted above, it is advisable and makes better sense to add assets and mutual fund schemes, wherein there is a low correlation with one another so that the risk is reduced.

Consider this, let's assume that an investor is looking to invest in two popular Large Cap Funds, Fund 1 and Fund 2, assuming that it will help him/her in diversifying the portfolio. However, on analysing the portfolio holdings, one would realise that the two schemes have 25 common stocks. The top-10 holdings of the schemes have 7 common stocks. Evidently, the two schemes have high portfolio overlap and therefore, adding both schemes in the portfolio will not offer substantial diversification.

Schemes within the same category may have high overlap

The securities quoted are for illustration only and are not recommendatory.
Portfolio data as of December 31, 2023
(Source: ACE MF, data collated by PersonalFN)
 

Investing in schemes across different sub-categories such as Large Cap Fund, Mid Cap Fund, and Flexi Cap Fund is a great way to diversifiy the portfolio. While certain sub-categories, such as Mid Cap Funds and Small Cap Funds, are known for their high returns potential, they are highly vulnerable to market volatility. On the other hand, sub-categories such as Large Cap Fund, Flexi Cap Fund, and Value Funds are relatively less volatile and can generate steady returns. Therefore, by including schemes belonging to different sub-categories can help investors sail through the volatile nature of the market.

Likewise, it is also crucial that investors avoid concentrating their investment to a particular fund house.

At times, two or more schemes belonging to the same fund house may also share stark similarities with one another even though they belong to different sub-categories. This may happen because the schemes may be managed by the same fund manager and thus, the investment philosophy/style/strategies applied in the stock selection process may be similar.

The table below shows the top-10 holdings of a Large Cap Fund and Flexi Cap Fund belonging to a popular fund house. Despite belonging to different sub-categories, the two schemes have 38 stocks in common, while the top-10 holdings have 8 stocks in common.

Schemes within the same fund house may have similar portfolios

The securities quoted are for illustration only and are not recommendatory.
Portfolio data as of December 31, 2023
(Source: ACE MF, data collated by PersonalFN)
 

In such a case, if an investor has exposure to two or more schemes within the same fund house, it is likely that the schemes will mirror each other in terms of outperformance and underperformance cycle.

So, while you diversify, whether it can become counterproductive and fail to generate higher returns, always needs to be seen. Instead of owning multiple funds within a category (or fund house/investment style), one should carefully analyse the composition of the portfolio and then make informed decision.

How many funds you should hold in your portfolio will depend on several factors such as an individual's broader investment objective, risk profile, the financial goals, and the investment time horizon before goals realise.

Thereafter depending on the needs and investible surplus, individuals need to build the portfolio across categories, sub-categories and investment styles to achieve optimal diversification.

For an investor with small portfolio size (of say around Rs 2-3 lakh), 3-4 funds may be enough for adequate diversification, while for an investor with large portfolio size, 7-8 or a maximum of 10 funds may be sufficient.

What if you hold too many mutual fund schemes?

 

The end result of holding too many mutual fund schemes is that investors will be left with an over-diversified portfolio that perhaps generates average or below-average returns.

Another downside to holding too many schemes is that it makes periodic reviews and tracking the portfolio's performance an uphill task, is time-consuming, and it becomes difficult to rebalance the portfolio should the need arise. It is noteworthy that portfolio review is necessary to weed out the underperformers and ensure that the portfolio is on track to accomplish the envisioned financial goals.

How to create a well-diversified portfolio?

If you are holding too many schemes, here are some helpful ways to reduce the number of mutual fund schemes in the portfolio:

1) Redeem schemes that do not align with your financial goals

Many investors keep adding mutual fund schemes to their portfolios either driven by emotions, or influenced by peers/family, popularity of the fund, star rating, top performers of the recent past, etc., hoping that it will help the portfolio to deal with volatility. However, such investment may not always align with your risk profile, financial goals, or overall asset allocation plan. If individuals clearly define their financial goals, investment horizon, and risk profile, it will help them create a focused portfolio.

[Read: How to Set Achievable Financial Goals And Plan to Achieve Them]

2) Remove schemes with overlapping investments

If an investor hold multiple schemes within the same category, it is likely that they have invested in the same set of stocks with similar strategies. In which case, it will not add much value to the portfolio. For instance, if an investor own 3-4 Large-cap funds, it is unlikely that all of them will turn out to be outperformers, and they may end up earning returns in line with the market. The higher gains in 1-2 schemes may get nullified by lower returns in other schemes. Consider adding more schemes within the same category only if they follow distinct investment styles or strategies.

[Read: Mutual Fund Portfolio Overlap: What it Is and How to Avoid It]

3) Eliminate consistent underperformers

Consistent underperformance of a mutual fund scheme relative to the category peers and the benchmark index is an important signal for you to consider moving out of it. The scheme that one has invested in should be capable of limiting the downside risk during bearish phases by falling less than the benchmark and peers, and generating higher returns than the market as well as the peers during bull phases. However, avoid judging the scheme/s based solely on its short-term underperformance, say 6-months, 1-year, etc. Also, avoid comparing the performance with a scheme belonging to another category.

[Read: How To Check If A Mutual Fund Scheme Is A Consistent Performer Or Not]

To conclude

Adding too many mutual fund schemes to the portfolio can make the crucial task of monitoring your portfolio a challenging exercise. Investors may even end up with a portfolio consisting of underperforming schemes, schemes with overlapping investments, or an unsuitable asset mix.

Therefore, investors should include only those schemes in the mutual fund portfolio that aligns with their financial goals and personalised asset allocation plan. Avoid adding too many risky funds to maximise the returns.

Review the portfolio periodically (at least once a year) to see if it is well placed to achieve the set financial goals. When reviewing the portfolio, check whether there is a need to weed out the underperforming schemes and replace them with a more suitable alternative. Also, check if there is a need to rebalance the portfolio so as to align it with your personal asset allocation plan.

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DIVYA GROVER is the co-editor for FundSelect, the flagship research service of PersonalFN. She is also the co-editor of DebtSelect. Divya is an avid reader which helps her in analysing industry trends and producing insightful articles for PersonalFN’s popular newsletter – Daily Wealth letter, read by over 1.5 lakh subscribers.
Divya joined PersonalFN in 2019 and has since then used stringent quantitative and qualitative parameters to analyse funds to provide honest and unbiased research to investors. She endeavours to enable investors to make an informed investment decision and thereby safeguard their wealth.


Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.

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