Mutual Fund Portfolios: Balancing Diversification and Excess
Diversification Trap: The Downside of Holding Too Many Mutual Funds
Investors often attempt to diversify their portfolios by adding a large number of mutual fund schemes. However, this approach may have unintended consequences. Analysts warn that holding too many mutual funds can lead to overcrowding and overlapping investments, ultimately hurting portfolio returns.
According to Nikunj Saraf, CEO at Choice Wealth, an oversized portfolio can create complexity, duplication, and behavioural fatigue. This is due to the increased complexity of tracking and rebalancing investments, which can lead to inertia or poor decision-making.
The first and most common trap of holding too many funds is overlapping. This occurs when multiple funds hold the same large stocks, particularly in categories like large-cap and flexi-cap. As a result, returns get diluted, and costs remain higher due to multiple expense ratios. Narender Agarwal, Founder at Wealth1, notes that over-diversification can lead to average returns, defeating the purpose of active fund selection.
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| Category | Number of Funds | Returns | Cost |
|---|---|---|---|
| Large-cap | 3-4 | High | High |
| Flexi-cap | 2-3 | Medium | Medium |
| Mid-cap | 1-2 | Low | Low |
| Multi-asset | 1 | Medium | Medium |
| Gold | 1 | High | High |
While there is no magical number, most wealth advisors and financial planners recommend that 4-6 funds spread across asset classes and stock categories can take care of the majority of the needs of an investor. Jitendra Solanki, a Sebi-registered research analyst, notes that anything beyond five funds won't really help in the diversification process.
A diversified portfolio should be built around clear roles for each fund, not around the number of schemes, according to experts. The idea is to combine funds that complement each other across market capitalisation, investment style, and asset class. Solanki suggests spreading funds across large-caps, flexi-cap, mid-cap, multi-asset, and a gold fund. Large-cap funds should ideally form 50-60% of the portfolio, and investors can also look to add an index fund in place of a large-cap fund.
| Fund Type | Ideal Allocation (%) |
|---|---|
| Large-cap | 50-60 |
| Flexi-cap | 20-30 |
| Mid-cap | 10-20 |
| Multi-asset | 5-10 |
| Gold | 5-10 |
In addition to these funds, investors can consider adding debt funds, gold funds, or international funds depending on their goal. The key is to avoid duplication and make sure each fund adds a distinct purpose to the portfolio.
Investor Takeaway
Avoid holding too many mutual fund schemes to prevent overlapping and ensure effective diversification.
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