Many mutual fund investors rue how deciding on an adequate number of funds in their portfolio is a problem for them. There is no thumb rule to decide how many funds one should invest in. However, novice and inexperienced investors tend to put money in more mutual funds. Most of them do this to diversify their investment portfolios while others invest looking at the novelty of the funds as in “Quant Concept” or “Momentum Concept” that add grandeur to the funds’ names.
However, exceeding a certain threshold, investing additional funds does not contribute to diversification. Also, this behaviour leads to cluttered portfolios with most funds having overlapping stock, thus, defeating the purpose of investment. In reality, having an excessive number of funds leads to a portfolio that resembles an index fund.
What is the ideal number?
The concept of an “ideal number” of funds in a portfolio is not universally fixed, despite many individuals opting for a portfolio consisting of 10-12 funds, which may include thematic funds. The intention behind this approach is to maximise market returns during specific cycles, although it is not necessarily a universally agreed-upon strategy.
Viral Bhatt, Founder, Money Mantra said, “There is no one-size-fits-all answer to this question, as the ideal number of mutual funds in your portfolio will vary depending on your individual circumstances and investment goals. However, as a general rule of thumb, I recommend having between six and seven mutual funds in your portfolio. This number provides you with enough diversification to reduce your risk, while still allowing you to focus on your specific investment goals.”
Here are some factors to consider when determining the ideal number of mutual funds for your portfolio:
Your risk tolerance: If you are risk-averse, you may want to have fewer mutual funds in your portfolio, as this will help to reduce your overall risk. However, if you are comfortable with more risk, you may want to have more mutual funds in your portfolio, as this will give you the potential for higher returns.
Your investment goals: If you are saving for a short-term goal, such as a down payment on a house, you may want to have fewer mutual funds in your portfolio, as this will help you to keep your risk low. However, if you are saving for a long-term goal, such as retirement, you may want to have more mutual funds in your portfolio, as this will give you the potential for higher returns over time.
Your investment knowledge: If you are not very familiar with the stock market, you may want to have fewer mutual funds in your portfolio, as this will make it easier for you to track and manage your investments. However, if you are comfortable with the stock market, you may want to have more mutual funds in your portfolio, as this will give you more flexibility to choose funds that meet your specific investment goals,” added Bhatt.
Getting rid of over-diversification
So, how does one redeem the portfolio of so many funds? Deciding to reduce the number of funds in a portfolio is not an easy task. For starters, the most important question is “Why should I reduce the number of funds in the portfolio?” Only then, one must go looking for the answer to the next pertinent question “How to reduce the number of funds in your portfolio?”.
To start with, check the percentage weight of every fund in your portfolio. Not all funds may be carrying the same weightage. It may be best then to redeem the funds assuming the lowest weight in your portfolio.
Eliminate funds with a weight of less than five to seven per cent in your portfolio: These are funds that might have been invested a while ago or wherein you may have discontinued putting in your money through systematic investment plans (SIPs). Alternatively, you may have made small, irregular investments on an ad hoc basis in the past.
Since these funds have a relatively small allocation, they do not significantly impact the overall returns of your portfolio. Even if these funds perform exceptionally well, their contribution to the overall performance of your portfolio would be minimal.
Exit funds with overlapping stocks
What is the use of index funds when you already have funds pertaining to large-cap, mid-cap, and small-cap funds? Most importantly, if you have two or more index funds in your portfolio, chances are that they would have overlapping stocks. This holds true for large-cap funds too. Do not have more than one or two large-cap funds. Remove those funds and retain only those that offer substantial exposure to large-cap investments.
Dev Ashish, a SEBI-Registered Investment Advisor and Founder (Stable Investor) advised, “There are several passive index options ranging from market-cap-based indices like Nifty50, Sensex, Nifty Next 50, Nifty Midcap 150, etc. to new factor-based indices (Value, Momentum, Quality, Low Volatility, etc. But you don’t need all of them in your portfolio. Just having one to two such funds is enough to build a solid, low-cost, low-maintenance investment portfolio. For large-cap exposure, investing in a passive fund that is based on Nifty50/Sensex/Nifty100 is enough. In fact, this alone is enough for most investors looking at passive options. For others who want to further diversify their passive exposure, they can pick from one of the passive midcap funds or factor-based index funds for a smaller exposure. But that is about it. Investing in too many passive schemes replicating the same index is a futile exercise.”
Active funds remain a favourable choice in the mid and small-cap space. While passive funds are not necessarily inferior, the lower market maturity in the lower market-cap segment justifies paying a slightly higher cost for active funds, as they may potentially offer better returns. However, it is important to avoid excessive diversification within mid and small-cap funds. It is recommended to limit your holdings to a maximum of two funds in each of these categories.
Never keep underperforming funds
Tired of funds that have failed to perform since you first bought them? Well then, get rid of them. However, this does not mean that you just view the last two years’ results and decide to redeem certain funds. Check the fund performance since inception or over the past five years. Allocate sufficient time to assess funds and their managers accurately. Evaluate their past performance over rolling periods ranging from one to 10 years, comparing them to both peer groups and benchmarks. If a fund consistently lags behind its benchmark and peers within its category, it is advisable to promptly consider exiting such underperforming funds.
Apart, check for news that could have led to their downfall. If the market has been bearish for a prolonged phase, check for the funds’ performance when the market was at its peak.
Avoid thematic funds
In a bid to earn high returns, many investors allocate a major part of their earnings to sectoral or thematic funds. It is common for individuals to invest in sectoral or thematic funds based on their short-term bullish outlook on specific sectors. However, over time, if your portfolio becomes overcrowded with multiple sectoral funds, it is wise to consider exiting a significant portion of them. While sector funds may seem appealing for the potential of accumulating a larger corpus quickly, most individuals do not require them for long-term financial goals.
No NFOs, please!
Mutual funds are queuing up with new fund offers (NFOs) every week. So many investors are enticed to put their money in them thinking that they would benefit from the lower net asset value (NAV) in the long run. However, this wrong thinking has caused many investors to continue with non-performing funds.
The NFOs when launched only discuss the asset allocation but do not divulge details of which stocks they would invest in, thus, leaving investors clueless about the funds’ possible performance in the future.
If your portfolio consists of an excessive number of funds, it is crucial to exercise caution when conducting a portfolio clean-up. Gradually and systematically existing schemes over a period of time can help minimise, if not eliminate, the impact of taxes and exit loads. It is important to prioritise a careful and strategic approach to ensure a smooth transition while minimising any associated costs.
If you intend to streamline and reorganise your disorganised and haphazardly planned portfolio, take action now. It is better to address this issue late rather than never. Your investment portfolio should align with your financial objectives. Choosing mutual funds randomly out of curiosity or greed will not yield any substantial benefits.