A guide to mutual fund diversification

Many of us strive hard to invest our hard-earned money in the right asset classes to meet our life goals. A good investment strategy is not only about maximising returns but also keeping the risk low, or alternatively, earn returns that are commensurate with the risks one takes. Diversification of investment across asset classes with varied risk-return profiles is one way of achieving this. While diversification helps reduce risk, how does one ensure that diversification in risky asset classes such as equity mutual funds minimises risk and aids returns?

Here are four things you need to keep in mind while looking at equities as an asset class to diversify your investment risk.

M-cap diversification

First, if you are investing in mutual fund schemes, ensure there is market cap-based diversification. For instance, parking all or a significant portion of your surplus in large-cap funds will increase the concentration risk. This is because most large-cap funds tend to own a set of blue-chip stocks which have a significant weight in the underlying benchmark index.

Let us assume that you have a total investment corpus of ₹10 lakh in mutual funds. Of the ₹10 lakh, ₹8 lakh is parked in large cap-oriented funds, say Axis Bluechip and Aditya Birla Sun Life Frontline Equity. With this, your total exposure to HDFC Bank is ₹0.9 lakh, about 9 per cent of your total mutual fund investment, which is quite significant.

Having such a high single-stock exposure can add to your risk quotient, should there be any negative news flow pertaining to that company.

Likewise, given that both the funds invest more than three-fourths of their assets in large-cap stocks, the effective overlap at the scheme level can be significant since several blue chip stocks such as ICICI Bank, Infosys and L&T may be common holdings across these schemes. Hence, when you look at investment in mutual funds, it is important to also look at the portfolio as well as the overlap in the portfolio across the schemes.

Second, if you have invested in direct equities or equity shares of companies, you need to ensure that you don’t hold the same stocks that are among the top holdings of the mutual funds you’ve invested in. This can increase the concentration of your overall equity portfolio even without you realising it. For instance, if you have invested in mid-cap-oriented mutual funds and also own shares of mid-cap companies, it is important to understand the overlap between your funds and your direct equity portfolio, and accordingly rebalance your portfolio, if necessary.

Even though holding promising stocks that are also being held by fund managers may seem a nice idea during good times, it can hurt you badly when the going gets tough for these companies. So, check for any overlap between your equity fund portfolio and your direct equity investment to reduce concentration risk.

Top-down approach

Third, a top-down approach to asset allocation for equity mutual funds will help you better manage risk. For instance, before investing in mutual funds, decide on the corpus you want to set aside for mutual fund schemes, and define the allocation to large-, small- and mid-cap schemes. Once this is done, you can look for schemes that have delivered consistent performance over a period of time and then invest accordingly. This will help you spread the risk better as well as maximise your returns. Also, investing in a fewer number of funds will help you track your portfolio better and thereby reduce the risk of return erosion.

Finally, do not invest in thematic schemes unless you understand the sector well. While thematic funds may seem like a good diversification strategy, chances are that you may be caught on the wrong foot if you cannot time the entry and the exit well in thematic funds. And for all you know, you may already be exposed to these stocks through your investment in other sector-agnostic equity mutual fund schemes.

The writer is an independent financial consultant