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Friday, June 10, 2016

How many Mutual Funds should you hold to adequately diversify your portfolio?

If you ask that question to your friendly fund agent, he may say: "The more the merrier. The more funds you have the more diversified will be your portfolio." From his point of view, the answer may seem logical. 

If you listen to his suggestion, you may end up with 15 or 20 funds. There are so many funds to choose from - large-cap funds, mid-cap funds, small-cap funds, multi-cap funds, FMCG funds, banking funds, infrastructure funds, arbitrage funds, funds of funds, balanced funds, ELSS funds, gilt funds, short-term debt funds, long-term debt funds, income funds, liquid funds, gold funds, and so on.

After a year, you will find that your portfolio has under-performed the fixed deposit rates of banks because the good performance of some of the funds have been neutralised by the poor performance of the others.

So, what should a small investor do? The answer is: It depends. On what? On where you are in your investing/wealth-building stage.

If you are a young person who has just joined employment, investing your meagre monthly salary savings in one good balanced fund may serve your purpose and provide adequate diversification. 

The equity component of a balanced fund can comprise a mix of large-cap and mid-cap stocks. The debt component can comprise a mix of government securities, company fixed deposits, NCDs. 

The equity component takes care of growth. The debt component minimises downside risk. A balanced fund with 60-65% equity component is treated as an equity fund. That means they are not subject to long-term capital gains tax and dividends paid are tax free. 

Someone who has been working for a while, or is running a successful small business, more substantial monthly savings may be available for investment. In which case, a large-cap equity fund, a mid-cap/small-cap fund, an ELSS tax saving fund, a gold fund and a debt fund should provide adequate diversification.

What about all the other types of funds mentioned earlier? Aren't there money-making opportunities in them? 

Yes, if you have nothing better to do than monitor the performance of your funds regularly. Then you will be in a position to move in and out of your funds to increase returns - most of which may be eaten away by fees and taxes.

No, if you want your funds portfolio to run on auto-pilot while you spend your time and energy in furthering your career or growing your business.

Many investment advisors - particularly the ones who work in wealth management divisions of private banks - are clueless about what constitutes an adequately diversified funds portfolio.

Typically, they give you a suggested list of funds that are 5-star or 4-star rated by or and expect you to choose from them. 

You may end up with 8 or 10 funds all of which hold Infosys, Reliance, L&T, HDFC Bank, Tata Motors among their top holdings. In which case, the performance of all your funds may depend on the performance of just these 5 stocks - giving you hardly any diversification.

You will be better off just buying these 5 stocks and not buying any of the suggested funds.

Remember that the more funds you have, the more time you will need to spend in monitoring their performances. Also, proper fund selection to avoid duplication of holdings will give you better portfolio diversification.

Last, but not the least, avoid the newer funds. Choose established funds that have a long-term returns track records.

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