Many mutual fund investors invest in two to three mutual fund schemes from three or four different mutual fund categories in the name of diversification. So, it is not uncommon to come across a mutual fund portfolio with 12 or 15 mutual fund schemes. The logic is very simple: three ELSS funds, three large cap funds, three multi cap funds, three mid cap funds, three small cap funds, three value funds…
Yes, these investors were diversifying their investments into different categories and schemes. What is wrong with that?
To begin with, investing Rs 1,000 or Rs 2,000 in too many schemes do not actually result in diversification. Ask yourself: what is the purpose of diversification? You are diversifying across assets to bring down the overall risk and maximise returns from your investment portfolio. Does the above strategy offer you these two benefits? Not really.
One, look at these funds. All of them are from the same asset class: equity. That means all of them may fall at the same time – only the extent of damage would differ. For example, the large cap or value fund categories fall less than, say, the mid cap or small cap categories.
Two, do these investments bring down the overall risk in the portfolio? When you add every possible category without paying attention to your profile, you might be doing the opposite. For example, a conservative investor adding mid cap and small cap categories could be counterproductive. Similarly, adding sector funds just for the sake of diversification may backfire.
Three, in some cases it might help to bring down the overall risk, but it might also drag the overall returns. For example, if a mutual fund investor diversify too much into gold funds could help him to bring own the risk, but it will also bring down the returns.
Also, when you pick three or four schemes from each category, you might be investing in the same set of stocks without realising it. Yes, many mutual fund schemes in the same category may have same stocks in their portfolio, especially the top holdings. Unless you check thoroughly the portfolio, you may be duplicating your portfolios.
That brings us to the question: is there are an ideal number of schemes one can have in a mutual fund portfolio? Well, most investment experts say an average investor do not need more than four schemes, including tax saving schemes, in the mutual fund portfolio. We believe there is nothing sacrosanct about this number.
It is more of matter of convenience. When you are investing a modest amount, it is always better to have a focused portfolio to maximise returns. When you dilute the focus in the name of diversification, the overall return from the portfolio also comes down. This can be problematic for a small investor. However, the same is not case with someone with a very large investment. Such a person can add more schemes.
You should also consider the practical difficulty of monitoring the portfolio while adding schemes. Unless you are extremely diligent, it may be a huge task for you to monitor the performance and take follow-up actions. You may be able to spot the underperformance of a category or scheme, but you won’t be able to able to further research and do the corrective actions immediately. That too on a regular basis.
That is why most mutual fund advisors ask investors to limit the number of schemes in the mutual fund portfolio to four to six.