There is strong evidence that risk can be reduced only to a certain extent beyond which there is no material benefit from diversification.
By Vikash Agarwal
Recently I met a consultant from one of the top consulting firms. We were discussing his investments and during my interaction, I discovered he had monthly investments in 15 mutual funds. Perplexed with his portfolio, I enquired the reason for the long list of funds. He explained that he wanted to maximize returns by investing in as many funds as possible.
Just like my consultant friend, many others believe that investing in more number of mutual funds is a route to manage risk better and generate higher returns. Well, I cannot deny that some amount of diversification is preferred and intuitively, the higher the number of funds, the higher is the likely diversification quotient. However, there is strong evidence that risk can be reduced only to a certain extent beyond which there is no material benefit from diversification.
To understand this perspective better, let us see what happens if we add too many mutual funds to our portfolio. But before that, what do mutual funds do? So, mutual funds essentially pool money from a lot of people like us and use their in-depth expertise to invest the collected pool into financial instruments (stocks, Govt. securities, bonds, etc.). And why do they do this? Because this is how they give people like us the desired exposure to good financial instruments and at the same time mitigate risks to a large extent by distributing investment across a diverse range of instruments (Example: 20 – 40 stocks in an equity mutual fund). Since mutual funds are handled by expert fund managers, they generally optimize their portfolio (risk – return reward) by investing in multiple instruments. Their objective is not only to mitigate risk by diversification but also to generate returns in excess of the benchmark.
Now, if an investor has invested in 4-5 equity mutual funds, he will normally own 100-150 stocks from the broader market which is enough diversification to generate returns which beat the benchmark. However, if an investor keeps on adding mutual funds to his portfolio he may actually own the entire market and may generate returns which do not beat the market in the long run. The returns may be replicating index returns (passive investing) for which an investor would be paying active fund management charges. In other words, if you over diversify, you may not lose much, but you wouldn’t gain much either. Another peril of investing in 10-15 mutual funds is that managing the investments becomes a complicated task with no additional reward. It is difficult to monitor and track the performance of 10-15 mutual funds and take corrective steps wherever and whenever required.
The ideal way to construct an equity mutual fund portfolio is to invest in 4-5 diversified equity funds depending upon the financial goals and risk appetite of the investor. We also suggest investors to invest in mutual funds of different fund houses to mitigate concentration risk with a particular Asset Management Company (AMC). The investment portfolio should be monitored on a semi-annual/annual basis and re-balanced if required. A particular mutual fund should be replaced or removed only if there is a change in the goals or risk appetite of the investor. Similarly, depending on required asset allocation, 2-3 debt funds may be included in the portfolio.
Just like too many cooks spoil the broth, too much diversification can prevent you from fulfilling your financial objectives.
(The author is CFA Director and Co-founder, CAGRFunds)