What’s the adequate number of mutual funds an investor should hold in a portfolio?

Funds selected with both strategic and tactical asset allocation in mind ensure that your portfolio is robust yet flexible.

Investing in mutual funds (MFs) is a popular strategy for building a well-diversified portfolio, but how many are ideal to hold?

Because too few can lead to under-diversification, while too many can create complexities and inefficiencies. Let’s see the key factors determining the right number of MFs for your portfolio based on diversification goals, asset allocation, and strategic considerations.

Aligning fund choices with goals and asset allocation

Aligning your portfolio with investment goals and asset allocation strategy is the first step in deciding how many MFs to hold. Whether your goal is long-term growth, income generation, or capital preservation, the selection of MFs should reflect these objectives. Strategic asset allocation involves spreading your investments across various asset classes like large-cap, mid-cap, small-cap, sectoral funds, debt, and thematic funds to balance risk and reward. An investor can consider allocation to a maximum of two funds in each category.

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For example, holding a mix of equity funds, including large-cap for stability and small-cap for growth potential, allows you to capture market growth across different segments.

Debt funds add an element of safety to reduce volatility of a portfolio.

Funds selected with both strategic and tactical asset allocation in mind ensure that your portfolio is both robust and flexible.

Avoiding fund overlap

One of the common pitfalls investors encounter when holding MF is fund overlap, where different funds have the same stocks or bonds. This may lead to unintentional concentration in specific sectors or companies.

To avoid this, use a process of elimination to select funds with distinct strategies. For instance, you may choose a growth fund, a value fund, and an international equity fund, ensuring each serves a different purpose.

Moreover, sector overlap can reduce diversification benefits. For example, holding two technology sector funds might expose your portfolio to excessive risk if that sector faces a downturn.

Regularly reviewing and rebalancing your portfolio will help prevent overlap and maintain diversification.

Core vs. satellite funds

A well-structured portfolio often has a core and satellite approach. The core comprises broad-based, long-term funds such as index funds or large-cap equity funds that form the foundation of your portfolio. These are stable, lower-risk funds that track the overall market. In contrast, satellite funds are more specialised, targeting specific sectors or strategies such as emerging markets, thematic funds, or small-cap stocks.

For tactical asset allocation, the number of satellite funds can be kept low. These funds can take advantage of specific market opportunities and trends, but too many can make your portfolio unwieldy and challenging to manage. A balanced mix of core and satellite funds, focusing on solid fundamentals keeps your portfolio lean and efficient.

Managing exposure and performance

Another key consideration is limiting exposure to individual companies or sectors. For instance, setting a cap on the size of any single company’s holdings within your MF ensures that no single stock overly influences your portfolio’s performance. A typical guideline is to ensure no more than 10-15% of your portfolio is concentrated in a single company or sector.

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Additionally, it’s crucial to compare each fund’s performance against relevant benchmarks. Look for funds that consistently outperform their benchmarks while aligning with your risk tolerance and investment horizon. Whether you prefer active funds, where managers aim to beat the market, or passive funds, which track market indexes, the key is to focus on performance while avoiding duplication across funds.

Growth v/s value: Making tactical calls

Lastly, the satellite portion of your portfolio can reflect growth vs. value investing styles. Growth funds focus on companies expected to increase earnings rapidly, while value funds invest in undervalued stocks with the potential for recovery. You can adjust your satellite holdings using tactical calls based on macroeconomic factors, such as interest rates or oil prices.

For example, when interest rates rise, you may favour funds with shorter-duration bonds, or when crude oil prices climb, energy sector funds may perform well. By keeping a macro and micro view of economic cycles, you can tactically adjust your portfolio for optimal performance.

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What’s the magic number?

Generally, a portfolio's ideal number of MFs ranges between eight and 12, depending on the investor's goals and risk tolerance. This range allows sufficient diversification across asset classes without overwhelming the investor with too many funds to manage. Regularly review and prune underperforming funds and avoid over-diversification, which can lead to complexity without added benefits.