Too Many Funds Spoil The Fun

Though diversification is important, it needs to be followed intelligently so as to gain maximum returns from your investments. After all, quality always counts more than quantity

It is not uncommon to find investors holding more than 20 funds in their portfolio and still not getting the expected risk-adjusted returns. It has also been observed that the number of holdings increases with an investor’s years of investing. Consider the case of Vikram Shukla who followed sage advice to start investment with his first job. He has completed 12 years with his company and now holds 23 mutual fund schemes in his portfolio. Every time his personal banker calls him and suggests some funds, he tries to get a second opinion from his friends and if convinced, he goes ahead to invest in it. And that’s the arithmetic behind 23 funds in 12 years.

All these investments were done under the pretext of either diversification or better returns or both. Compare this with his friend Chetan Pandey, who holds only six funds and has yet managed to generate better returns than his friend Vikram Shukla. This entire episode is well-summarised by the quote of legendary investor Warren Buffett, who says. “Wide diversifica tion is only required when investors do not understand what they are doing.” Diversification is important; however, it needs to be followed intelligently. But before we tackle what intelligent and smart diversification means, let us understand how the number of funds impacts the overall risk return profile of a portfolio.

More Funds (≠)More Returns

In order to understand if higher number of funds means higher returns, we carried out a study. Our period of study was between the start of 2017 and the end of 2020. We started with 11 equity-dedicated mutual funds. There is no particular reason why we selected 11 funds; we wanted it to be more than 10 funds, which we consider to be a higher number for a mutual fund investor if all are not allocated to different financial goals. The funds were selected from large-cap, mid-cap, small-cap, sectoral and thematic categories. We constructed an equally weighted portfolio of these funds. The following table shows the summarised performance of portfolios’ with different number of funds.

Returns: The graph below shows the annualised return of the funds. It increases initially, except when we moved from ten funds to nine funds. However, after reaching a high of 13.76 per cent it started declining.


Risk: One may argue that rising returns are accompanied by rising risk represented by the volatility. Here too we do not see any increase in volatility or risk. At best it is inconclusive as we do not have a clear trend.

Risk-Adjusted Returns: One of the best matrices to determine the risk-adjusted return is the Sharpe ratio. The graph below clearly shows that as the number of funds decline in your portfolio, it increases your risk-adjusted returns. However, after a certain number of funds, it declines. So, in our study we found that six funds generate the best risk-adjusted return.

The above study clearly shows that more the number of funds do not mean more returns. There are various reasons why more funds may not result into better returns. First, most of the equity-dedicated mutual funds hold more than 20-30 stocks and if we add a few more funds and in turn a few more stocks, it will not make much of a difference until and unless they are not from different categories. Besides, it has been observed that diversifying beyond 20 stocks reduces the benefit of diversification and becomes a drag on performance. In other words over-diversification kills performance.

Too much diversification can make a portfolio underperform the market without providing greater risk reduction. Under the diversification flag, a financial advisor can make poor investment recommendations. Sometimes a tempting commission gets advisors to forget who they should be working for. Poor execution of a diversification strategy can definitely harm portfolio performance.

Intelligent Diversification

Diversification helps and there should be no doubt about that. However, it is only intelligent diversification that reduces potentially unproductive asset classes through a disciplined, mathematical, evidence-based approach. Always assign your portfolio to a financial goal even it is for wealth creation. Such a goal-based portfolio will give you the much required guidance on building a portfolio. It will help you to adopt a focussed investing approach and prevent any digressions and waste of time. Linking goals to the portfolio provides clarity and choice of appropriate mutual fund schemes.

Even considering all your goals, the number of funds should not exceed 10-12 considering you are investing in debt funds also. Besides, one of the reasons for limited number of funds in your portfolio is to make it more manageable as you can track lower number of funds more closely. Before adding any equity schemes to your portfolio you should check funds with similar category or style that are not already present in your portfolio. For example, if you already have a large-cap and mid-cap fund, there is no need to add another large-cap fund or mid-cap fund as chances are high that there will be duplication of stocks.

Besides the category you also need to add a different style to your portfolio, especially if you are holding funds for the long term. Different styles – for example, value and growth – perform differently in different market conditions. You cannot predict that market condition and hence it is better to prepare for any shift and diversify your portfolio accordingly. In the above case, it seems that Chetan was able to resist the temptation of any new fund offer (NFO) or chasing returns. Before adding any fund he asked himself two questions: Is the NFO offering something that is not already present in his portfolio or does it complement his portfolio? If not, he never invested in those much advertised NFOs promising high returns. Besides, he also knew that chasing returns helps only if you catch them early. Therefore, work out a tactical allocation for building up your core portfolio.