Is Over Diversification Good For Your Mutual Fund Portfolio? Know Here
Jun 28, 2018

Author: PersonalFN Content & Research Team


My friends and I have been planning a trip to Goa, but it still is a castle in the air. Whenever we are close to finalizing it, something comes up and postpones our adventure.

One friend wants a luxurious trip, while the other one wants a budget trip. Two of them would like to take this trip in December and the others, in May. With such a contrast of opinions, consensus is nearly impossible.

Remember, “Too many cooks spoil the broth”. This old proverb holds true even today.

Same goes with your investments too.

One of the basics of investing is diversification.  

And over diversification of your portfolio is unhealthy for wealth creation.

Let me tell you diversification of your portfolio across the asset classes and instruments is very important.

But diversifying in multiple schemes having a similar style and objective is definitely a mistake!

Investors look for the “best funds", “top funds”, “best performers”, and so on to make good returns.

As soon as someone knows I am research analyst, the first thing I am asked is, “Which is the best fund according to you”.

Or, “I recently invested Rs 1 lakh in XYZ mutual fund; do you think it is good?”

And then, it gets hard to explain to them this is not how you make smart, prudent investment decisions.

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.

So what style of diversification is ok?

Diversify your risk across investment styles

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

Begin with identifying your risk appetite as well as investment time horizon. Then accordingly, allocate your portfolio across asset classes and investment styles that will help you diversify your risk across market cycles and 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 Aggressive Hybrid Funds, Conservative Hybrid, Balanced Advantage, Multi-asset allocation, Arbitrage, Equity savings. Under debt category - Income, Liquid, Floating, Gilt, Ultra Short-Term Funds, Money Market Funds, Corporate Bond Funds and so on.

Indicative portfolio category allocation based on risk appetite
Category 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 High - -
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 facilitate long-term wealth creation.

Holding too many funds with a similar objective is a bad idea With too much diversification, you may overlook the risks and expenses. At times you may even do so to earn better returns.

For instance, many investors keep on adding star performers to their portfolio thinking that it will earn them extra returns. And while doing so they do not check the fund’s objective.

Investors forget that after every boom, there is a gloom; and these stars lose their shine.

Do remember that during a mid cap rally, all mid cap funds top the list and star rankings. Right after the downfall, these lag behind on the list and star rankings.

Moreover, you may not be lucky enough to add mid cap funds before the rally starts. You may have become heavy weight on them only when the mid cap rally is almost reaching exhaustion points. And then 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 of the exposure to a number of stocks in a single investment vehicle, holding too much of 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. Remember, 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, overlapping same underlying investments is possible. With multiple schemes having overlapping objective and investment style, you tend to increase the overall risk to your portfolio.

Once the underlying stocks or sectors start witnessing a dive, your over-diversification would not do any good to your portfolio.

Please note that every additional fund in your portfolio may add to the cost in terms of high expense ratio and multiple transaction cost. 

And any bad pick in your portfolio can affect the performance of your overall portfolio.

As a result, there will be an increase in expenses, but a compromise on portfolio performance.

Don’t forget 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?

Although there are number of mutual funds providing thousands of schemes to invest in, truly speaking, there is no magical number that is right which can help you build an optimal portfolio. 

Just remember, you don’t need to have a dozen of schemes in your portfolio to diversify your risk. Even a single diversified equity fund can diversify your risk in “n” number of stocks or multiple sectors. Only thing is, they may not include 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. Basically, the funds which stick to their investment mandate and are consistent performers.

Funds which are suitable for you as per your risk appetite and time horizon which help you meet your long term goals.

If you desire to build an ideal portfolio of mutual funds, here are some important points:

  • Primarily, look at holding funds that have different characteristics and behave differently

  • Try to limit the number of funds in your portfolio and feel comfortable with your holdings

  • Consider your investment objectives and goals. 

If generating regular income is your primary goal, then mid cap or sector fund may not be suitable to your portfolio; while if your objective is capital preservation, equity funds will not suit you.

Portfolio rebalancing is the key

The higher 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. Simply because they are unsure of what their actual holdings represent.

Hence, consider this:

  • 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 do not match your investment goals or have a similar mandate (say 3-4 large cap funds and 2-3 mid cap funds), it makes sense to exit and invest in a single fund having a more consistent track record in their respective category.

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

You need to take charge of your investments and avoid over diversification.

Remember, “Too much of anything is good for nothing!

If you are confused about the health of your mutual portfolio, the investment strategy, your own risk profile, and your asset allocation; do contact your investment adviser or investment counsellor to help you.

PersonalFN can get you best results powered by its ethical and unbiased investment advisers who will comprehensively review your mutual fund portfolio.

Opt for PersonalFN's Mutual Fund Portfolio Review service to check how healthy your portfolio is and get Buy / Sell / Hold recommendations on your existing portfolio, keeping in mind your investment objectives and financial goals. Act now!

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Happy Investing!

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