Too Many Stocks Spoil Your Portfolio?

The conventional wisdom says diversification helps in mitigating risk. DSIJ digs deep to analyse when diversification helps and when it does not.[EasyDNNnews:PaidContentStart]

A lot has been written about the importance and benefits of diversification. You might have heard this from your advisor, broker or anyone claiming to be a financial expert. Your investment experience might also have led you to believe that you should not put all your eggs in one basket. The modern portfolio theory upon which modern finance theory rests also advocates and proves that individual assets are riskier than a collection of different assets. Therefore, it makes perfect sense to diversify your investments. Your investment in a mutual fund scheme does this exactly for you. 

Nonetheless, there is a flip side to diversification, though. It has been nicely summed up in a word coined up by ace investor Peter Lynch in 'One Up On Wall Street' – diworsification. There are studies that show that a big part of the portfolio returns depends on striking the right balance in diversification. How many stocks a mutual fund scheme should hold? How many sectors should the scheme spread them across? Some industries and some stocks are just better than others, so simply diversifying for the sake of having exposure to all sectors is not necessarily a good idea. 

What The Data Says
To understand if there is any link between the number of companies being held by mutual fund schemes and the returns given by these schemes in the next one year, we did a thorough study. We took all the equity funds (‘regular’) since the end of 2015. We have taken only open-ended funds. We have excluded the ETFs and index funds as they follow an index and have to invest in the constant number of stocks that constitute the index. 

We studied 1864 schemes, out of which there were 717 funds from large-cap, 363 from mid-cap and 784 from multi-cap categories.

After ferreting out this data, we calculated the number of companies held by the fund at the end of a particular month. After that, we calculated the next one year return posted by all the funds. To make inference and conclusion easier, we created five different brackets of holdings. 

The Return Distribution The average return may hide some of the details in the data. Therefore, we studied the return generated by different categories of funds under different brackets. The table and graph shows that the average returns generated by the different market caps under different brackets. It is evident that for different categories, the average returns pick up at different holding brackets. For instance, in the case of mid-cap funds, the average return is highest when the holdings are in the range of 71 to 90, whereas in the case of large-caps, the average return is highest between 51 to 70. 

The Analytics
To understand if there is any relation between the numbers of companies held by a mutual fund and the next one-year return, we did a regression analysis where we studied the relation between next one-year returns to the current period holdings. Contrary to the normal belief that a concentrated portfolio generates better return, we found that as the number of companies held by a MF scheme gets higher, the returns generated by them also get higher. For every one company added into the scheme, the returns increased by a negligible 0.08%. It is statistically robust and we can rely on that. R square of 1.5% shows how much returns of the mutual fund scheme depend on the number of companies held by the fund. 

Although, the impact of holdings is not high on future returns, it has a bearing in the next one-year return. 

We did the same study even for the individual categories. We found that the relation of higher the holdings, higher the return generated for the next one year is greater in the case of mid-cap funds. The value of R square also improved to 0.04 and for every company added into the fund and the returns improved by 0.1 per cent. For large-cap funds, the R square stands at 0.02, while every extra stock added only 0.08 per cent. 

In the case of multi-cap funds, our data shows that there is no relationship between the number of stocks in the fund and the returns generated by them in the next one year. 

Summing Up
Various domestic and international researches show that there is an inverse relation between the number of holdings and the return generated by the funds. Nonetheless, in our study, we found that at the broader level, there is a positive relation between the number of companies held by a fund and its one-year forward returns. 

However, if we go deeper and study category-wise, we find the relation is stronger in mid-cap funds as compared to the multi-cap and large-cap funds. Hence, we are giving you a list of mid-cap funds that have holdings between 50 and 70.