When it comes to investing in equity funds, Indian investors have a lot of choices. In fact, a little too much choice. There are almost 40 AMCs offering schemes in almost each of the 10+ equity fund categories. So just in the equity fund space, there are at least 300+ options for investors to choose from.
But while the choice of funds can get overwhelming, investors themselves don’t regularly review and clean up their mutual fund portfolios. Most investors start investing in a fund or two. But then, and over a period of next few years, they keep adding new funds to their portfolio. And most of them don’t look at cleaning up their portfolios.
The result is that very often, investors end up with a portfolio of an unnecessarily large number of funds. And it’s quite common to see several funds of similar types in portfolios in the name of diversification. But while diversification is important, it doesn’t mean that you keep adding new funds to your portfolio.
Investing in too many funds, and justifying it as diversification, is redundant. Beyond a point, there are no additional (diversification) benefits available if you increase the number of funds in the portfolio.
Let’s understand this with a few examples to drive home the idea.
Suppose you decide to invest inlargecap funds. And to ensure that you are properly diversified, you pick 3 active large cap funds and 1 large cap index fund. Now you may feel that you are diversifying well. But the reality is different. As per SEBI’s categorization rules, a large cap fund needs to invest at least 80% in stocks of only the top-100 companies.
Now if you open the bonnet (or underlying portfolio) of each of these large cap funds, you will see a lot of similar names as the universe of stocks available to be invested is limited by SEBI rules.
So, to a large extent, each of the funds you have chosen will have a lot of overlap with each other. There will be no real diversification if you increase the number of pure large cap funds in your portfolio. Just investing in 1-2 large cap funds, whether active or passive or both, is more than enough for most investors.
If you really want to diversify, you need to invest across different fund categories and not just within a category. That way, the above-average performance of one category can offset the underperformance of another category at any given time.
That was about large cap funds. But what about other popular categories like flexicap funds, midcap funds, smallcap funds?
While passive funds are advisable for large cap funds, for mid-&-smallcap exposure, there is still a lot of potential for alpha generation via active investing by good fund managers. So, if one has to not have too many funds in the mid & smallcap categories, then one can go for 1-2 proven, well-managed, activemidcap funds and depending on the size of the overall portfolio 2-3smallcap funds.
For picking funds from theflexicap category, 1-2 funds are enough provided the inter-scheme overlaps are limited and there is style diversification.
But it must be noted that midcaps and smallcaps can be very volatile in the short term and hence, the total exposure to these two market segments, across all funds combined, should be limited to a maximum of 30-40% for most investors. The rest 60-70% should be to large caps.
There is no one right answer to questions like how many funds should I invest in. But just adding new funds to the portfolio to ‘diversify’ or reduce risks doesn’t work.
So, in general, having 1-2 schemes in the chosen fund category would be sufficient. That is assuming one doesn’t have too many fund categories in their mutual fund portfolio in the first place.
Dev Ashish is a SEBI-Registered Investment Advisor and Founder (Stable Investor). He provides fee-only financial planning and investment advisory services to small and HNI clients across India.