Too many funds spoil the fun
Many studies have been carried out around the globe with respect to diversification and many of them have concluded that diversification indeed helps in managing portfolio risk in an efficient way. So, what is this diversification all about?
Diversification is nothing but spreading your investments across various assets and instruments. This helps you to reduce your dependence on a single asset or security. In stocks, diversification means investing across securities from different sectors that are uncorrelated to each other. On the other hand, in mutual funds, diversification means spreading your investments across asset classes.
What happens when you invest in too many funds?
Many a time, people invest in a lot of funds thinking that they are diversifying their investments. In fact, with this approach, they are actually over diversifying their investments, which does not hold much significance. Remember, equity mutual funds invest in stocks, and typically, one fund invests in around 50 to 100 stocks. Therefore, if you buy more funds of the same sub-asset class, there are chances of stocks overlapping. Let us understand it better with an illustration.
Here, we have assumed that you are investing in two large-caps, two mid-caps, and two small-cap funds. In large-cap funds, we have assumed that you invest in Canara Robeco Bluechip Equity Fund (Scheme A) and ICICI Bluechip Equity Fund (Scheme B). In mid-cap funds, we have assumed that you invest in HDFC Mid-Cap Opportunities Fund (Scheme A) and DSP Mid-Cap Fund (Scheme B). And in small-cap funds, we have assumed that you invest in Nippon India Small-Cap Fund (Scheme A) and Franklin India Smaller Companies Fund (Scheme B).
As evident from the above graphs, even after considering only two funds in each category, we saw more than 10 per cent of overlapping. Further, it is more in case of large-cap funds. This is because the stock universe is restricted to the top 100 stocks by market capitalisation and they also need to have a minimum of 80 per cent assets dedicated towards it.
Therefore, if you are investing in a large-cap fund, then only one fund is enough. In the case of mid-cap and small-cap, a maximum of two funds is advisable. This will ensure that you have a minimum overlapping of stocks. Further, one must not forget to diversify across asset classes. This means you should also consider investing in debt funds.
Finally, you do not require more than eight funds in your portfolio for proper diversification. For high net-worth individual (HNI) and ultra-high-net-worth individuals (UHNI) investors, a maximum of 15 funds is more than enough for enjoying diversification benefits.