Mutual Funds

Too much diversification is bad

G Pradeepkumar | Updated on March 15, 2020 Published on March 15, 2020

In equity, it can diminish return potential, but diversify aggressively in debt funds

While investing in mutual funds, an investor must always take a portfolio approach. What this means is that for an investor who has invested in multiple funds, there can be individual funds that may or may not be performing at a particular point in time, but the investor and the advisor must evaluate the portfolio as a whole and see how the portfolio is performing.

It is similar to how fund managers create portfolios — not all the stocks may perform, but the portfolio as a whole must deliver returns. In this context, it is recommended that investors take a somewhat different approach to their portfolios of equity and fixed-income funds.

Equity

One of the most significant benefits of investing in mutual funds is lowering of risk through investment in a diversified portfolio of securities. While this is perfectly true, one needs to be careful not to overdo it. One common mistake that many people make is having investments in a large number of funds. While diversification is essential to lower the risk, too much of it can actually be counterproductive.

Consider this, if an investor buys 20 different equity mutual funds with an average of 50 stocks in each of the funds, effectively, she could end up owning more than 300 stocks even after accounting for overlaps. Having these many stocks in one’s portfolio is equivalent to buying pretty much the entire market and hence, you may only end up getting market returns. Factor in expenses, and the returns on your investment may even fail to match market returns.

One must remember that, in general, risk and reward move together and if you try to reduce the risk too much, the returns also may come down. For most people, having about five equity funds would be more than adequate to meet their goals.

The picture is different in the case of fixed-income funds. While fixed-income securities typically carry lower risk than equity, they are not free from risk.

There is risk of default by any of the companies in which the fund has invested. Fund managers take care to ensure that investments are made in high-quality companies, but sometimes things can go wrong as it happened in the case of IL&FS and a few other companies in recent times.

Debt

At the same time, potential gains from a fixed-income security tends to be limited. For example, you could have a stock that goes up by 50 per cent or 100 per cent in a year, but you would be very unlikely to see that kind of return from any fixed-income security. So, by having a concentrated portfolio on the fixed-income side, one could have a situation of limited upside and higher risk.

For an investor, it is important to minimise her exposure to any single company. The best way to do this is by diversifying the holdings across various fund houses such that the exposure to a particular issuer would be brought to a minimal level.

For example, suppose fund A has invested in company ABC, which forms 5 per cent of the portfolio of A.

But if the investor spreads her investments over 10 different funds, the exposure to ABC may be as low as 0.5 per cent of her overall portfolio. Even if something goes wrong with ABC, only 0.5 per cent of the investor’s portfolio would be at risk.

And finally, if all this is too confusing, take the help of a good distributor/financial advisor. A good advice is always worth paying for, whether from a doctor or from a financial advisor.

The writer is CEO, Union AMC

Published on March 15, 2020

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