‘Portfolio diversification’, as a concept, is much like Soan Papdi for the investing community. It is transferred from one person to another but is hardly consumed by anyone. The reason is not that people do not understand its importance; rather, they don’t know the exact math behind it.
Diversification means spreading your investments across instruments to minimise the risk. But what combination of instruments will achieve the result, is sometimes hard to figure out.
For instance, buying shares of 10 different companies will help you minimise company-specific risks. But if these 10 shares belong to the same sector, you’ll expose your portfolio to sector-specific risks. And that’s precisely why this is not called optimal diversification.
This mostly happens when investors try to create a mutual fund portfolio. We believe that schemes with different names or different categories have disparate strategies, but this is not always the case.
Take, for example, Axis Bluechip fund and Axis Flexi-cap fund. Both funds belong to different fund categories, but have 92 percent overlapping. If you compare the portfolio holdings, you will realise that the two schemes have 28 common stocks. This means, adding both schemes to your portfolio will not diversify your risk.
If you have too many mutual fund schemes in your portfolio and want to optimise it to avoid overlapping, here’s how you can do it:
Avoid buying too many schemes of the same category
It makes no sense to buy multiple schemes from the same category, especially in the case of large-cap funds. As per SEBI’s regulations, a large-cap fund has to invest at least 80 percent of its assets in large-cap companies, which are ranked 1st to 100th on Indian stock exchanges in terms of market capitalisation. On the other hand, if you see the indices like Nifty 50 and BSE 100, the composition is mostly similar, which makes it difficult for a large scheme to beat the index. Additionally, as the investible pool in the case of a large-cap scheme is very small, there is hardly any scope for a fund manager to adopt a different strategy.
Check sectoral allocation
Compare your mutual fund schemes and determine their exposure towards different sectors. In case you find that two or more funds in your portfolio have similar sectoral allocation or the net allocation towards a sector is very high, you should reconsider your investment weightage.
Avoid adding multiple funds managed by the same fund manager
Though it’s compulsory, it’s ideal for diversifying your portfolio at the fund manager as well as AMC level. The reason is that funds managed by a single manager are likely to have a common investment strategy as his views towards sectors and stocks would be similar irrespective of the type of fund he manages. Similarly, you will also find certain resemblance at the AMC level, due to a common research team. So, ideally, you should limit your exposure to 30-40 percent towards a fund manager or an AMC.
It’s true that diversification helps you in risk mitigation, but only up to a certain number of additions. When you invest in too many schemes, there are high chances that he could invest in the same stocks. Also, if in case the underlying holdings are different, you may end up owning the entire market, which makes it tough to generate alpha. The right approach to diversifying is to have 3 to 4 funds with different investment strategies in the correct proportion.
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