Safeguard your Mutual Funds portfolio from over-diversification

07 Nov 2019

Investing directly into equities requires expertise and hard work. For layman investors who don’t have the ability or time to choose the right stock to build a robust portfolio, they should move to a mutual fund for long term investing.

Diversification with mutual funds becomes easy when you buy funds that represent different sectors and asset classes. However, people end up investing in too many funds at the same time. Having too many funds in the same group could lead to over-diversification risk.

Let us understand this through the following example - An investor can diversify risks through allocation into four different funds, one large-cap stock fund, one small-cap stock fund, one international equity fund, and one bond fund. Each of these will likely hold completely different securities when compared to the other.

Let us understand the disadvantages of overlapping and ways to avoid it below.

Duplication or overlapping of funds:

Selection of funds while constructing your portfolio is fine, but an investor should also know when to stop adding. This brings us to a pertinent question – How much is too much? You can find anywhere between around forty to sixty stocks across different sectors in a typical diversified equity mutual fund. You may have several different funds in your portfolio; the problem when some of them have many similarities, it is called an ‘overlap’. The weight assigned to various stocks can differ, but the names will overlap. So you are choosing four different funds from different AMC’s, but end up holding a similar type of sector or assets.

Disadvantages of overlapping of funds:

The most significant problems of overlapping are that you will never receive an incremental value in terms of returns if you keep adding similar funds to your portfolio. Having too many funds can bring down the average returns of your portfolio because, at any given point in time, some funds may be doing well while others not so much. Also, over-diversification makes it that much more difficult for you to manage and monitor your funds without yielding any significant incremental returns on your overall investments.

How to avoid overlapping of funds?

Aligning portfolios with sectors of higher allocation in benchmark indices is possible in large-cap, large and mid-cap and multi-cap funds. The best strategy is to pick around four to eight different funds that have a distinct approach, with a low overlap and align to your long-term goals. To avoid overlapping, be sure that your fund holdings are indeed from different fund categories. Therefore, you can expect long-term growth from a diversified basket of stocks. Apart from diversifying across market capitalization, investors can also diversify across investment styles.

To sum up, diversification is akin to satisfying the common tenet “Do not put all your eggs in the same basket”. On the flip side, however, over-diversification is counter-productive and makes it that much more difficult for you to effectively manage and monitor your funds without yielding any significant incremental returns on your overall investments.

Therefore, protect your MF portfolio from the perils of over-diversification.

Founded in 2005 by new–age entrepreneur Abhishek Bansal, the Abans Group has evolved into a globally diversified conglomerate, providing expertise in Broking Services, Non-Banking Financial Dealings, Financial Services, Agri-Commodity Services, Warehousing, Realty & Infrastructure, Gold Dore Refinery & Manufacturing, Trading in Metal Products, Pharmaceuticals, Software Development & Wealth Management. The Group is a comprehensive financial and non-financial services and solutions provider, aiming to provide end-to-end solutions to its clients.