Diversification, as you know is the basic tenet of investing. A well-diversified portfolio of mutual funds is all you need to achieve your various financial goals. Jimmy Patel, MD & CEO, Quantum Mutual Fund explains how holding too many similar funds can drag your portfolio returns, during an interview with Himali Patel .
What is meant by a well-diversified portfolio?
Does it mean that you keep adding new mutual fund schemes to the investment portfolio in order to earn better returns and minimise the risk? The basic idea behind diversification is not about adding more number of similar asset classes. Likewise, holding a plethora of similar category of mutual fund schemes can cause more harm than good. Surely, it will provide you with a little bit of everything (help diversify), but not enough of anything (optimally diversify). As a result, while you would diversify, it may not help achieve the intended objective like minimise the risk during volatile market conditions, and earn better risk-adjusted returns in the long run.
What should investors do to have the right mix of diversification?
To achieve the intended objective as highlighted above, it is advisable and makes better sense to add assets and mutual fund schemes, wherein there is a low correlation with one another so that the risk is reduced while your broader objective is capital appreciation. For instance, if you have three mid-cap funds in your portfolio, during a market rally in these stocks, maybe they would do well. But the test of these will be during the downswings of equity markets, where only fund/s, which are less susceptible to the downside risk like fare better during the bear phases of the equity markets, will be worth holding in the investment portfolio than all schemes in the same category.
You will recollect that while most mid cap funds did well when the markets were rallying, not all generated luring alpha after the market hit turbulence. Instead of owning multiple funds within a category, you can merge your contribution in one scheme that has a relatively consistent track record compared to others. It is important to hold only the best within each category and sub-category to yield better risk-adjusted portfolio returns. That is what optimal diversification is.
How many funds you should hold in your portfolio?
This will depend on several factors such as your broader investment objective, your risk profile, the financial goals and the investment time horizon before goals are realised. Thereafter depending on your needs and investible surplus, you need to build the portfolio across categories, sub-categories and investment styles to diversify across large-cap funds, large mid cap funds, mid cap funds, small cap funds, multi cap funds, and value style funds.
For an investor with small portfolio size, 3-4 funds may be enough for adequate diversification, while for an investor with large portfolio size, 7-8 or max 10 funds may be sufficient.
How to build a worthy mutual fund portfolio?
Ignoring your financial and lifestyle needs while selecting mutual fund schemes can prove detrimental to your financial wellbeing. You may get stuck with an unworthy scheme and lose track of your target. So, avoid rushing into and investing your money in any and every New Fund Offer (NFO) that hits the market.
Likewise, when a scheme comes to limelight with impressive returns registered in short period of time, delve deeper to recognise the reason/s, put that fund on your watch list—to check for consistency––and then take a call whether it would be a worthy addition in your investment portfolio based on the aforesaid factors and the asset allocation best suited for you.
What is the best way to pick the right scheme?
The best way to pick the right scheme is to check the consistency of the fund’s performance and compare it with the benchmark and category peers by evaluating it on various quantitative - qualitative parameters.
So, here are a few quick to-do points for optimum portfolio diversification:
Avoid investing in multiple schemes with overlapping portfolio, investment objective and style
Select funds only after careful need-based analysis and a host of quantitative and qualitative parameters
Opt for funds with a consistent performance track record across time frames, market cycles, and do not go only by star-ratings and/or popularity of the scheme
What if investors do not possess the expertise to select winning funds? Is it possible to achieve optimum diversification with a single fund?
Yes. Select an efficiently managed equity Fund of Fund (FoF) that holds promising mutual fund schemes, which have the potential to build wealth for you, without over-crowding your portfolio.
A Fund of Fund (FoF) invests in units of mutual fund schemes of the same fund house and/or of other mutual fund houses. A minimum of 95% of the scheme's total assets is invested in the underlying fund/s.
So, instead of a portfolio of stocks, debt, and money market instruments, the portfolio of FoF comprises of a range of mutual fund schemes in various compositions. Simply with one fund, you can gain exposure to multiple mutual fund schemes managed by various fund managers.