Diversification helps reduce risk. But, what is the best way to diversfiy one's portfolio? Sanjay Matai discusses the pros and cons of various methods of diversification, and helps you choose the best one.

The benefits of diversifying one’s portfolio are, of course, known to all. It helps align our investment portfolio with our financial-cum-risk profile. It protects us from any downside in one particular asset class.

As each one of has a unique financial-cum-risk profile, each one of us must

1. Build a suitable mix of investment across various assets classes viz. debt, equity, real-estate, gold etc.
2. Even among the broad asset class like debt or equity, there are sub-classes. One must diversify suitably across these sub-classes too. For example in debt one must invest suitably in Bank FD, NSC/KVP and PPF etc. Or in equity one has to diversify across large-cap, mid-cap, small-cap, sector-specific.
3. Going further, even within particular sub-class say large-cap equity, one has to choose a mix of individual stocks.

The overall approach is a top-down one i.e. starting from the broad allocation across asset classes, you move down to choosing individual investment options. (Also read - How to build your MF portfolio?)

We could invest separately in each of the individual option as per our desired allocation strategy. This approach gives us the total flexibility to choose what we want. We have full control over our financial decisions. But this approach

• can become a bit cumbersome
• requires one to have the time and the knowledge to identify and invest separately in individual opportunities. This is more particularly true of building and managing one’s own equity portfolio, where things are more dynamic and risky as compared to debt
• a fairly large corpus is needed to achieve the desired diversification
• the transaction costs could work out to be high
• the tax efficiency is low

Mutual Funds offer some simplification and tax-efficiency, but this so far is limited to equity and debt. We may, however, shortly see real estate and gold funds too. Even within say debt all instruments are not included such as PPF, where we would still have to invest separately.

Further, Mutual Funds also offer different routes to achieving the desired diversification. (Also read - How to reduce risk while investing?)

The choice of route usually does not affect the overall returns, which is more a result of the ultimate choice of funds that we make under a particular route.

The fund-of-funds route

A fund-of-fund is a single scheme, which enables us to invest across different mutual fund schemes of different types.

Say we want to have 60:40 equity-debt asset allocation. Then there could be a fund-of-fund scheme, which would invest 60% corpus in say 4-5 diversified equity funds, 20% in 2-3 long-term debt funds and say 20% in 2-3 short-term debt funds. Moreover, these funds could either be from the same fund house or across different fund houses.

Thus, here with investment in just one fund, we can get the desired asset allocation. Also, this fund-of-fund route is highly tax-efficient at the time of portfolio rebalancing. (Also read - 7 investment tips to improve your returns)

Though easy to understand, tax-efficient and simple to operate, it is not a very flexible approach and also the costs may be slightly higher. Second, as on date there aren’t too many fund-of-fund schemes, which invest across various fund houses. Most of them invest in their own schemes. So we don’t get the fund-house diversification.

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