Diversification is one of the most common selling points in mutual fund investing. Buying into one diversified fund will instantly gain you access to a multitude of stocks across sectors and market capitalisation. However, many investors go one step further and ‘diversify’ by holding lots of funds. This isn’t always a good thing.

Diversification is an attempt to invest in a variety of securities/investment avenues so that an economic downturn that affects one instrument does not end up having a cascading effect on the entire portfolio. In simpler words, it is the process of not putting ‘all the eggs in one basket’.

However, the tendency to accumulate various funds results quite often in a great overlap of stocks, sectors, themes or even markets of a particular country.

Let us take the example of investor Mr A. He explicitly wishes to invest only in blue chip companies and therefore chooses four different large-cap funds in the hope of diversification. What actually occurs is as follows:

Large Cap Mutual Funds Top 5 Holdings No. of Stocks
SBI BlueChip HDFC Bank, Larsen and Turbo, HPCL, Nestle India, ITC 58
MotilalOswalMost Focused 25 Maruti Suzuki, HDFC Bank, HDFC, Kotak Mahindra Bank, Max Financial Services 20
Mirae Asset India Opportunities HDFC Bank, ICICI Bank, State Bank of India, HDFC, Infosys 55
Kotak Select Focus HDFC Bank, Reliance Industries, Hero Motorcorp, HDFC, State Bank of India 56

(Source: Value Research, Data as on 13th November 2017)

Notice anything? For one, the top five holdings of these four funds have several common stocks while HDFC Bank features in all of them. Secondly, the holdings are a good indicator as to which sector the funds are leaning towards currently (no prizes for guessing, finance). Thus taking exposure to even two of these funds would result in simply copying the stock selection of the other, which is not really diversification.

In another instance, Mr B decides to invest into Flexi Caps believing that fund managers have a more flexible mandate to invest across the stock universe based on their views on the market. This makes him believe that diversification is a more realistic possibility. He narrows down to choosing one or more of the following funds:

Flexi/Multi-Cap Mutual Funds Top 5 Holdings No. of Stocks
Franklin Prima Plus HDFC Bank, BhartiAirtel, ICICI Bank, Infosys, Yes Bank 51
ICICI Value Pru Discovery Sun Pharma, Larsen and Turbo, Wipro, HDFC Bank, NTPC 40
Adita Birla Sun Life Advantage HDFC Bank, State Bank of India, HPCL, Maruti Suzuki, Reliance Industries 56
DSP Black Rock Opportunities HDFC Bank, Tata Steel, Yes Bank, ICICI Bank, State Bank of India 69

(Source: Value Research, Data as on 13th November 2017)

You can see a similar trend here too with HDFC Bank being common amongst all and the Financial Services sector ruling the top picks in most cases.

Apart from this overlap, which nullifies the diversification effect, having a long list of funds has its own perils.

  1. You end up owning the whole market and lose out on the compounding ability of a concentrated portfolio
  2. The longer the list, the more difficult it will get to manage, review and monitor the funds over time.

How to diversify

When it comes to achieving diversification, an investor should ideally look for at least one of the following from a fund:

  1. Addition of an asset class such as equity, debt and gold. Each asset class brings its own unique value to the table and therefore reduces the risk for the portfolio as a whole.
  2. Addition of an investment style. e.g: a fund looking primarily to invest in value stocks.
  3. Addition of a new subset of the equity or debt market. Eg. choosing a fund that invests in the small cap markets or a fund that looks to invest into government bonds. As shown in the example above, multi-cap funds can also be dominated by the same large-cap stocks as their large-cap peers. So do check the fund’s portfolio and the fund manager’s investment style.

More often than not, if a fund does not fulfil at least one of these objectives, you may want to reconsider adding it to your portfolio. Always bear in mind the purpose of investing in a mutual fund is to get the necessary diversification. More important factors such as risk appetite and investment horizon would play a role in deciding how much you will end up investing in each fund.

Author
Debendra Das

The author is a private wealth manager and financial advisor. The views are his own. Feedback to this article may be sent to contact@rupeeiq.com.