Are Mutual Funds Enough For Portfolio Diversification?

You may think that by investing in various MFs you are adequately diversified, is it so? DSIJ explains what are the different asset classes and how can you diversify your portfolio in the true sense.



More and more investors have become increasingly aware of investments in mutual funds in the last few years and have increased their MF investments. However, the recent decline in the equity markets and paper downgrades in the debt markets have led many retail investors to redeem their mutual fund investments. The situation becomes scarier in the case of investors who have invested in direct plans, where the rate of redemption is higher than the regular plans. This is the first serious decline in MF investments witnessed by many investors who started investing after 2013, which shows the level of confidence investors have in mutual funds. But the problem starts with the MFDs (Mutual Fund Distributors) or, for that matter, anyone who is selling mutual funds to the investors. They try to convince their clients that mutual fund investments are one of the safest options as compared to other asset classes. Here lies the gap between the perception and the reality. First of all, investors should understand that mutual funds are in no way a safe investment, at least not as safe as your savings bank account or bank FDs (fixed deposits). Any MF investment does carry some amount of risk with it. If you are expecting great inflation-adjusted returns from mutual funds, then you should be ready to inherit a great amount of risk by default.

Many investors believe that since mutual fund schemes invest in various companies, they are adequately diversified. But the reality is altogether different. To understand this, let us first take a look at the broad asset classes, apart from mutual funds. These are real estate, alternative investments (including private equity and angel investing) and commodities, including gold. So, if we look at the broader asset categories, then you may not be adequately diversified even if you have invested in various equity mutual funds. This is because the MFs may have invested only in equities. But why do we need to invest in different asset classes? To understand this, let us check these broad asset classes in brief and look at their performance.

Real Estate

Real estate is often held as a part of a larger portfolio and is generally considered to be less liquid. Although the introduction of REITs (Real Estate Investment Trusts), which are going to be launched soon and will be traded in the secondary market, will make them liquid, these are yet to be introduced in India. Real estate goes well as part of your portfolio because it has several traits that help in enhancing the returns of an overall larger portfolio and/or reduce the overall portfolio risk.

Alternative Investment Fund

AIF (Alternative Investment Fund) can be viewed as any investment that is not a traditional investment like equities, fixed income or real estate. These include private equity, angel investing, venture capital investing, hedge funds, etc. However, these instruments usually involve big ticket investments.

Commodities

Commodity investment means investing in various types of physical goods or products. This can be used as investment, or many a time, it can also be used for hedging purpose, especially by producers as well as end-users. The prices of these commodities depend on their demand and supply in the market. As far as commodities are concerned, they are not meant for investing, rather they are meant for trading or hedging, with the exception of gold and silver, which can be used as investments.

As SEBI has a taken a positive stance and is likely to allow mutual funds to invest in commodity derivatives, you can see a lot more mutual fund schemes using them to enhance their returns or minimize the risk. But, at the moment, we need to wait and watch when SEBI allows it and how these would perform.




Let's get practical

For most of us, if we invest in a few mutual fund schemes, we feel we have a well-diversified portfolio. The reason behind the same is that mutual funds not just invest in stocks, but they also invest in corporate debt securities and government securities. Some schemes also invest in gold. As per the recent media reports, SEBI may allow mutual funds to invest in commodity derivatives. This would increase the spectrum of sub-asset classes in which mutual funds can invest.

However, if you wish to invest in broader asset classes individually and diversify your portfolio in the real sense, then you need a really big-ticket size as the other asset classes require huge investments.

For example, if you wish to invest in real estate (and not in companies engaged in the business of real estate), then you need big money to purchase property, be it residential or commercial. To make investment in real estate a bit affordable, SEBI has allowed retail participation in REITs. Still, the minimum investment amount is Rs. 2 lakh.

For some investors, REITs would be one of the ways to diversify their overall portfolio, but many investors may not be able to afford the desired minimum investment amount of Rs. 2 lakh. In case of AIF, an individual investor needs to invest a minimum qualifying amount of Rs. 1 crore.

In the case of commodities, though the investment is not too big, it calls for an expert knowledge as the returns from investing in commodities can be very volatile and also each commodity has its own market dynamics and cycle. The minimum amount with which you can start investing in a commodity is Rs. 5000. However, you have to pay the margin money, which is generally 5-10% of the commodity product and varies from product to product.

Summing up

Diversification plays an important role in generating returns on your investment. The rationale behind diversification is that any economic activity has different implications on different asset classes. Hence, what's good for the equities may not be as good for the commodities. To ensure your portfolio is responsive no matter what the economy is doing, you may want to include most of the broader asset classes as part of your holdings.

If we look at it in a practical manner, we find that some of the asset classes have a very high qualifying amount of investment and hence these are beyond the reach of a retail investor, which deprives him the benefits of diversification. Therefore, mutual fund investing in different asset classes such as equity, debt or commodity is advisable. The actual investment should be made in consultation with your financial advisor and should be based on your risk profile and your financial plan. 

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