Many investors often question whether they are holding the right number of mutual funds in their portfolio to achieve their financial goals. The general assumption amongst investors is that if they keep adding popular, star-rated funds to the portfolio or newly launched funds, their portfolio will be well-diversified and in a better position to deal with market volatility.
By doing so, investors often end up accumulating 15-20 mutual funds or more in their portfolio. The fact is, over-diversification is counter-productive to creating wealth.
As the saying goes “Too much of anything is good for nothing”. This means, beyond a point, every scheme you add to your mutual fund portfolio…
- Just occupies a place in your portfolio
- Offers no extra benefit
- Doesn’t help lower risk
- Increases the burden of monitoring
- Discourages optimum use of resources
All the benefits of diversification viz. lower portfolio risk, optimal returns, and stability in performance can be actually achieved with a lesser number of schemes. Therefore, it is important to know exactly how many schemes you should hold in your portfolio to optimise wealth creation.
Mutual fund schemes by nature usually invest in a well-diversified portfolio of securities to reduce the stock/sector specific risks; so, when you add one scheme too many to achieve optimal diversification, it is pointless.
Most individual investors require not more than 5-10 mutual fund schemes, depending on the size of the portfolio. These would include schemes across equity mutual funds, debt mutual funds, hybrid mutual funds, and ELSS funds.
If you are stuck with a large number of schemes and are looking to downsize it, here are some helpful ways to correct your portfolio:
1) Remove schemes with overlapping portfolio
If you hold multiple schemes within the same category, it is likely that they have invested in a same set of stocks with similar strategies. In which case, it will not add much value to the portfolio. For instance, if you own 3-4 large-cap funds, it is unlikely that all of them will turn out to be outperformers and you may end up earning returns in line with the market. This defeats the purpose of investing in actively managed schemes that usually charge a higher expense ratio to generate alpha.
To achieve optimal diversification, align your investments to your goals, risk appetite, and investment horizon, and then invest accordingly — equity funds are ideal for long term goals, debt funds for short term goals, and so on. Trim your allocation to riskier segments such as mid-cap funds and small-cap funds (or credit risk funds in case of debt investments) if you do not have a very high risk appetite. This will help you to monitor the progress of the schemes in achieving your goals.
2) Eliminate consistent underperformers
Keep track of the performance of the schemes in your portfolio. If you find that a scheme is consistently underperforming its benchmark and the category average, eliminate it. However, do not take the decision solely on short term underperformers. The fund should be able to actively participate during recovery and bull phases, while simultaneously being able to protect the downside risk better during bear phases.
To check whether the scheme is a consistent performer, analyse it on various risk-reward parameters such as, performance across market phases and cycles, Sharpe Ratio, Sortino Ratio, Standard Deviation, etc. While determining the consistency of a scheme’s performance, bear in mind the importance of its quantitative parameters such as, the portfolio characteristics of the scheme, the efficiency of the fund house, and the quality of the fund management team.
3) Look before you leap
It can be tempting to invest in sectoral funds that may have generated double-digit returns in the recent past or an attractive looking new fund offer (NFO). However, you should avoid adding these schemes to your portfolio. Sector funds are highly risky due to the concentrated nature of their portfolio; timing the entry and exit in the scheme becomes important when you invest in these funds. On the other, when you invest in an NFO, there is no reliable track record of the fund’s performance, portfolio quality, risk-return profile, etc. that will help you determine if it is a worthy scheme for your portfolio.
It would be better to invest in a diversified portfolio spread across categories, sub-categories, and investment styles and stick to it until your goal is achieved. Add a new scheme to your portfolio only if it can aid in diversification and aligns with your investment objective.
Things to consider when you offload schemes from your portfolio
Consider the costs and tax implications when you are looking to exit the scheme. Most mutual fund schemes impose exit load if the investment is redeemed (including switches) within one year. Second, you may be liable to pay capital gain tax on the gains made from redeeming investment.
In case of equity funds, long term capital gain tax will apply at the rate of 10% if redeemed after one year (only on gains of over Rs 1 lakh in a financial year) and 15% in case of investments held for less than a year.
For debt funds, investment of more than three years is considered as long term and the gains are taxed at 20% (excluding surcharge and cess) with indexation benefit. In case of investment of less than three years, the gains are taxed as per the investor’s income tax slab rate.
Review your portfolio periodically (at least once in a year) to see if it is well placed to achieve your goals. When you review the portfolio, check whether there is a need to weed out the underperforming schemes and replace it with a more suitable alternative. Also check if there is a need to rebalance the portfolio so as to align it with your personal asset allocation plan
This article first appeared on PersonalFN here