How many mutual funds should you have in your portfolio?

While diversification is important for any investment portfolio, owning too many funds is useless. Diversification is not about having as many funds as possible. In fact, no additional diversification benefits are available by investing in more funds beyond a certain point. There is always a right amount of diversification. And if you have more of it, i.e., over-diversification, it doesn’t help. Most investors can do with having just a small number of funds of different types (from different categories).

Let’s take an example. Suppose an investor has four large-cap funds. Now, a large-cap fund, by definition (and SEBI’s categorization rules), needs to invest 80 per cent of its portfolio in large-cap companies (which are defined as top 100 companies by market capitalization). So, all the four large-cap funds will invest from more or less the same set of 100 companies. These four funds from one category (large cap) would simply mirror each other’s portfolios (to a large extent). And, this leads to duplication. Having a large number of similar funds only swells the portfolio. The investor will not get additional diversification by investing in these many large-cap funds.

Another aspect is that the four large-cap funds portfolio will only produce returns that a large-cap index does. If that’s the case, then there is no point investing in active funds at all. Instead, you can simply pick one large-cap index fund. It will be cheaper and easier to manage as well.

Exploring fund categories

In the above example, it would have been better for the investor to diversify investments across fund categories. That way, the good performance of one category can offset the underperformance of another category.

Time and again I have heard that many investors (who already have too many funds) have an erroneous view that risk gets reduced continuously with each additional scheme they buy for their portfolios. But that’s not the case actually. You can only reduce risk to a certain point, after which there are no additional benefits from additional diversification.

Is there are perfect answer to how many funds are enough?

Like all things in personal finance, even this doesn’t. Different investors would need different approaches. But, in general, having 1-2 schemes in chosen fund category would be sufficient. That is, assuming you don’t have too many fund categories in your portfolio.

In equity funds, when you add more funds beyond a few, you are basically adding more stocks in your underlying portfolio that might be identical to what you already have via the existing funds. But, on the other hand, it makes sense to diversify aggressively in debt funds. Even if it means being a bit over diversified.

If you have too many funds in your portfolio, then review your mutual fund portfolio and do the cleanup exercise to reduce the clutter. If you are unable to do it on your own, take help from your investment advisor. Having an MF portfolio that’s scattered doesn’t serve its purpose properly. Cleaning up will require you to exit certain funds and it will have a capital gains tax implications. It is important to systematically trim the number of funds over a period of few months so that the impact of the taxes and exit loads can minimized.

(The writer is the founder of StableInvestor.com)