Is there a need to invest in multiple schemes of the same fund categories?

I have often maintained that there is a place for both active and passive funds in an investor’s portfolio. Going passive-only is fine as well if investors are willing to take a bit of additional risk – then they can have active funds for mid- and small-cap exposure and passive funds for large-cap exposure.

Comparing schemes in same category

As per the rules, each asset management company is allowed to offer only one scheme in a mutual fund category. And since the definition and internal rules for many of these categories are stringent, there is very limited scope for fund managers to offer something unique.

A case in point is the large-cap category. A large-cap fund by definition (and rules) needs to invest at least 80 percent of the money in large-cap companies – the top 100 by market capitalisation.

If an investor chooses four schemes from the large-cap fund category, there is bound to be a lot of overlap because 80 percent of the money has to be invested in more or less the same 100 companies.

To see the real picture, let’s see the overlap of the four largest active large-cap funds by assets under management:

That’s a lot of overlap among schemes within the category. In general, if the average overlap between two schemes is more than 50-60 percent, one should expect similar return outcomes from them.

And, more often than not, they will move in tandem. Hence, there is no diversification benefit from investing in such similar schemes.

Also read | Underperformance of active largecap funds widened in 2022

To be fair, many schemes in the flexi-cap fund category are also close to large-cap funds and behave in a similar fashion. So, for many investors who pick large-cap-oriented flexi-cap funds, there is a view that they don’t even need pure large-cap funds.

And since flexi-cap funds, by definition, give a lot of flexibility to fund managers to bring their own unique styles and strategies into fund management, having more than one scheme in the flexi-cap category can also be considered.

The same logic can be extended to the category of large and midcap funds and multi-cap funds, though the latter is a comparatively new category and is yet to build a long enough track record to be relied on.

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Moving on to the non-large-cap space, i.e., midcap funds and small-cap funds.

A deep dive into midcap and specially small-cap funds shows that the level of overlap in schemes in these categories is limited. So, schemes with less common stocks (and their weightages) will have unique portfolios.

Also, for mid- and small-cap exposure, picking proven, well-managed, active funds can be considered. This in no way means that passive options in the mid-cap space are bad.

Also read | How to reduce the number of equity mutual funds in your portfolio

However, the potential for alpha generation in this space, and more particularly in small-caps, is much higher. So, I think one can take the active route as it justifies the cost with the potential to outperform the index.

So, for midcap and small-cap categories, while a single scheme from each would be enough for smaller portfolios, having 1-3 schemes with limited overlap can also be considered for larger portfolios. Anything more will only lead to overdiversification and is unnecessary.

Summary

• For large-cap exposure, go for just one fund, preferably a passive index fund. For smaller portfolios of moderately aggressive investors, a large-cap-oriented flexi-cap fund can also be considered.

• Having more than one scheme from flexi-cap and/or large and midcap category is fine as long as there is style diversification and limited overlap and correlation.

• For midcaps, 1-2 schemes should be enough for most. At least one of the two can be a pure passive or passive-based factor fund too.

• For small-caps, it’s best to go via the active route. For larger portfolios, having up to 2-3 small-cap schemes can be considered.

• Following these guidelines will not only allow for stock, sector and market-cap diversification, but also different fund manager styles and AMC diversification, which are important too.

• What about sectoral and thematic funds? Most investors don’t need them.