Diversification through Mutual Funds. How many are enough?

Diversification through Mutual Funds

In a utopian world, every investor would make the highest returns while undertaking the lowest possible levels of risk. This outcome, however pleasing it may sound, does not come to fruition in reality. In times of high market volatility, an investor can only take as many precautions to protect himself from the downside and achieve proper exposure towards the upside. One way, however, to insure himself from the volatility is diversification. Diversification ensures the capital invested is allocated in such a way that exposure to any particular asset class is restricted resulting in balancing of risk. With the help of diversification, you do not have to put all your eggs in one basket. Instead, you can spread out your eggs into several different baskets across different tables’ altogether. This will ensure that even if one basket falls and the eggs in it break, your loss will be limited to the extent of how diversified you were. Mutual funds are one way to ensure that your risk is spread out across all the underlying securities in that fund. Further benefit can also be derived by investing in several different Mutual Funds across their market capitalisation.

As the saying goes, “Excess of anything is harmful”, excess diversification too can hurt your portfolio. Therefore the all-important question arises. How many funds should your portfolio have? There is no exact number as to when you can achieve maximum diversification as adding new funds will invariably increase the underlying securities. However, after a point, each additional fund in the portfolio will add new securities on a diminishing basis.

To help illustrate the above, we have constructed two portfolios. Portfolio A has 8 mutual funds spread across large, multi, mid and small market capitalisation. Portfolio B, on the other hand, consists of 22 funds also spread similarly as Portfolio A. The only difference being that Portfolio B has a significantly higher number of funds as compared to A. To research further Rs. 1100000 was invested in each portfolio allocated equally across all the underlying funds. Below are the results when Portfolio A & B are held from 2012 to date.

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It can be seen from the figure above, Portfolio A has generated higher returns as compared to the over diversified Portfolio B which holds almost 3 times the number of funds as A. The perceived benefit of having more funds in fact resulted in a decrease on investment returns disproportionately to the benefits received. Analysis of the reason as to why a portfolio consisting of fewer funds performs better over a period of time can be seen below with the help of the “Derived Exposure Charts”.

 A Derived portfolio is the aggregate of a person’s mutual fund holdings and analyzing the underlying investments of those mutual funds in the form of direct equity investments. Once a list of unique stocks that the funds hold is obtained, the derived portfolio gives the person a different perspective on the investment. It gives the overall analysis of a unique number of stocks held, which would help in understanding if there is an over-concentration in stocks or a sector or if there are too many unique stocks which could result into over-diversification of the overall portfolio which otherwise would have been difficult to trace.

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We can see from the above that diversification to an extent is necessary and proves to be beneficial over a period of time, however, after a point, adding more funds to a portfolio proves to be redundant. In case of Portfolio B, allocation in almost ~80% of the underlying securities are attained by investing in the 10th mutual fund. All investments after that point prove to be inefficient as exposure to any additional securities in restricted to a miniscule number. At this point, the portfolio suffers from duplication of the underlying securities which nullifies the entire concept of diversification itself. Another issue with over-diversification is that tracking all the investments becomes difficult. To review 20+ investments on a monthly basis could prove to be a nightmare for the investor.

The objective of investing is to create wealth in order to achieve certain goals and objectives. The prudent approach to be followed is to define your goal and objectives, determine the asset allocation and then proceed to the process of fund selection. 

To conclude, there is no specific number of funds one should hold. Funds in your portfolio should be incidental to the goals and objectives that you wish to achieve. However, steps should be taken such that risks of over-diversification does not creep into the portfolio. 

 

*For the purpose of calculations, actual performances of several equity mutual funds were considered for the period 31/12/2011-5/11/2017.

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