Money
How many mutual funds are needed for goal-based investing? And how diversified should they be?
Summary
- Investors can plan for their financial goals with a limited set of mutual funds and must avoid the pitfalls of over-diversification
How many mutual funds do investors need for their financial plans and to what extent should they be diversified? While several new mutual funds and even new categories have been introduced over the years, investors really don’t need more than eight-10 of them to attain their financial goals.
Depending on whether the goals are short, medium or long term, investments can be made in equity, debt or hybrid – a combination of equity and debt – funds.
Risk of over-diversification
Diversification is important, but doing so just for the sake of diversifying doesn’t work and can backfire. That’s because after a point, the benefits of diversification tend to peter out and dilute returns.
The risk of over-diversification occurs when incremental investments lower the expected returns to a greater degree than meaningfully reducing risks.
Over-diversification ends up spreading the portfolio too thin and ends up becoming just a ragtag of several low-conviction ideas with small allocations. As a result, the portfolio doesn’t meaningfully benefit from outperformance of a particular asset class or investment.
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Take large-cap funds. Several large-cap funds have similar portfolios – primarily heavyweight stocks of the benchmark Nifty 50 index. Investing in multiple large-cap funds doesn’t mean diversification – it just means holding the same stocks, which are large constituents of the Nifty 50 Index, in different funds.
As a result, the portfolio’s ability to outperform diminishes. A simple Nifty 50 index fund might be enough for getting large-cap exposure.
Smart diversification
To get it right, portfolios must be diversified with investments that have a low co-relation with each other, or better still, those that are inversely co-related.
The equity markets and gold are often inversely co-related. When stocks are volatile due to global risks or geopolitical tensions, there is increased demand for a safe haven like gold and its prices tend to rise during such periods.
Gold yielded returns of 28% over the past one year (as of 17 April), while the Nifty 50 Index returned slightly over 8%.
Stocks and bonds, too, have demonstrated a low co-relation over the years. Quality bonds stabilise a portfolio because debt investments don’t face the same degree of extreme price fluctuations as equity.
However, within the fixed income category, careful investing is required because certain categories of debt funds can be more sensitive to changes during interest rate cycles.
Long-duration categories such as gilt funds that invest in government securities are a case in point. These funds tend to underperform when the interest rate cycle moves up.
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One can even invest in debt through hybrid funds. Hybrid strategies like balanced advantage funds (BAFs) re-balance equity and debt in a more tax-efficient manner. A typical BAF buys equities when valuations are low, sells equities and increases debt exposure when equity valuations are expensive.
If investors re-balance equity and debt on their own, they would attract capital gains tax when selling the investments that need pruning.
Emerging markets like India and developed markets like the US too have a low co-relation, which is why overseas allocation is also important.
A study of three-year rolling returns of a 50:50 portfolio of India and US markets (re-balanced at the start of every year) shows lower volatility – closer to the US index S&P 500 – and performance closer to India’s benchmark Nifty 50. This study considered a 50:50 portfolio of both the benchmark indices, but investors can consider 8-10% international allocation for their portfolios.
Multi-asset allocation funds, as the name suggests, can be a one-stop solution for investors who want a single fund to take care of all of their diversification requirements. These funds invest in equities, debt, gold and international markets, with the fund manager deciding allocations based on his or her views.
Mapping funds with goals
For long-term goals that are longer than five-six years, investors can consider equity funds. For medium-term goals that are three-five years away, investors can opt for hybrid funds, and for near-term goals of less than three years, investors can consider debt funds.
It is even possible to diversify investments within a fund category. Among equity funds, the flexicap category – where the fund manager can freely invest across market cap buckets – investment styles may vary.
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Certain funds follow growth investment style, which outperforms during certain phases of the stock markets, while some funds follow value investing, which does better in other phases of the markets.
However, only use as many funds as needed to achieve goals. There are several fund categories that have emerged, including smart-beta funds and quantitative funds.
Go for such funds only after fully understanding their inherent risks and return profile. Alternatively, there are many funds that dynamically manage portfolios across low co-related asset classes.
Diversification for the sake of diversification is not healthy for a portfolio and can diminish the ability to capture upsides when a particular investment starts to outperform.
