When one invests in Mutual Funds and tends to choose diversification across multiple schemes. The common view is, this reduces the risk your money is exposed to. However, what really needs to be asked is, “Is there really is an ideal number of funds that should be in one’s portfolio?” Before answering this question, it is important to first set the agenda or objective of investing in actively managed Mutual Funds, Which to my mind is to beat the market (or perhaps an Index Fund or ETF), but why? Simply because an index fund or index ETF gives market returns at cost which looks negligible as compared with 1.8% to 2.4% of annual expense of actively managed funds. Therefore to sum up – the purpose of investing in actively managed funds is to beat the market returns (index returns).
The below mentioned illustrations will get us closer to the answer. Here’s a look at two – arguably extreme - scenarios, both with their pros and cons listed and explained:
Scenario 1: A single mutual fund in the portfolio, with all eggs literally in the same basket
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Pros |
Cons |
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It would be well-diversified in terms of minimal credit risk on stocks, as a Mutual Fund company typically invests in multiple stocks typically in the range of 20 to 200 different companies. |
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Not diversified across the individual fund manager’s risk.E.g. What if the fund manager is going through a rough professional/personal phase of life, which would impact on their fund’s performance?
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Scenario 2: Investment is too diversified, 15+ schemes in the portfolio
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Pros |
Cons |
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Diversified across credit risk of stocks, Asset Management Company (AMC), individual (fund manager) |
Different MF schemes (of similar style) will invest in similar stocks. E.g. all mid cap MF invest in very similar stocks |
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Investor won’t be able to manage E.g. Won’t sell the fund even if it’s doing poorly, as each individual fund contributed very little to the overall portfolio, i.e. investor will ignore its underperformance. |
Conclusion
This objective of consistently beating the index cannot be achieved by having too many (15 plus) funds in your portfolio as there are only few out-performers, and non-performance of the larger crowd becomes evident in the long term. So, having a portfolio of 6 to 7 mutual funds across categories shall be the best bet to achieve the mentioned goal, that would ensure two important things, firstly the investor would spend more time while choosing the schemes and secondly, it will lead the investor to take quick corrective action, whenever required.
The bottom-line is, investors must choose their goal wisely. Any goal that aims at beating the index consistently requires active management. Too many funds in the portfolio behaviourally represents a passive nature of the investor, which could be lack of bandwidth. In this scenario, ETF or index fund achieves the goal at a much lower cost. Thus, effective management of your portfolio comes down to understanding one’s bandwidth to manage the funds it contains versus the desire of consistently beating the index
