Many investors end up investing in way too many funds than what are needed for adequate diversification. Here’s why this is a serious problem and how you can solve it.
Many fund investors are also kind of fund collectors. They have loads of schemes in their portfolio, sometimes as many as 40 or 50 (or even more). Many reasons are responsible for this. Some investors chase past returns and load up on schemes in the process. Some are mis-sold funds, and they end up having more than they need. Some who want to save income tax buy a new ELSS (or multiple new ones) every year and since each investment has a three-year lock-in period, soon they are under a pile of ELSS funds. Still, some investors get fascinated by investment themes, NFOs, etc., and bite off more than they can chew. The result is the same: more funds than needed.
What’s the problem with that, you may ask. Well, even if you have got Einstein’s brain power, it still does not make sense to invest in too many funds. But more on this shortly. A related question is how many funds one should ideally have. The answer is four to five. If you think that’s too low a number, think again. An average mutual fund has about 40 to 80 securities (stocks or bonds). So, a fund is often well-diversified in itself. Thus, four-five funds from different fund houses can take care of diversification adequately.
Now let’s talk about the perils of having too many funds in your portfolio.
Why Not Invest in Many Mutual Funds?
Having too many funds in your portfolio has the following unintended consequences.
1. Dilution of Returns
If you hold 30-40 schemes in your portfolio, very few schemes will likely have a sizable allocation. Even if some of your funds give great returns, those won’t necessarily translate into superior returns at the portfolio level.
For instance, let’s compare two portfolios worth Rs.10 lakh each. One has 5 funds, and the other has 20 funds in it. Let’s say that the amount is also equally distributed across all the schemes. Now if one scheme gives a superior return of 22% per annum in both of the portfolios and all other schemes deliver an annualised return of 12%, the total corpus will be high in a portfolio with 5 funds. The same is depicted in the chart below.
Thus, the portfolio with five funds helps you accumulate Rs. 6.3 lakh more than one with 20 schemes in it.
2. Portfolio Becomes Index-Like
When you invest in too many funds, inadvertently you end up investing in a large number of stocks as well. This can compromise the benefits of active investing and make your portfolio returns index-like. However, your expenses (expense ratio) are not index-like as many of your funds would be actively managed. If getting index-like returns were your goal, that could be done by investing in an index fund, which would also have a low expense ratio.
3. Difficulty In Managing Your Portfolio
This is the obvious downside of investing in too many funds. You won’t likely be able to track the performance of individual funds and exit them when they have not been performing for an extended period. Managing taxes and filing returns could also become tricky when you have a plethora of funds.
How to Reduce the Number of Funds in Your Portfolio
Now that you know how excessive funds can be harmful to your portfolio, let’s look at some of the strategies which you can deploy to remove the unnecessary funds you hold in your portfolio.
3. Exit the Underperformers
Start by cutting down the underperformers. If a fund has been underperforming its peers or the benchmark for two years or more, it doesn’t deserve your money. Some investors fret about the taxes they may have to pay on selling the underperforming funds. However, the opportunity loss that you incur by investing in a poor fund is often more than the money you would save in taxes.
For example, let’s assume you had invested Rs. 1 lakh in a fund three years ago for a target time horizon of 10 years. In the last three years, the fund has given an annualised return of just 8% and it’s likely to deliver a similar return in the future as well. Now, you have two options.
- You can stay invested in the same scheme and continue to earn 8% returns. After 10 years, when you finally redeem the funds, your corpus will be as follows.
| Initial Investment amount | Rs. 1,00,000 |
| Total amount after staying invested for 10 years (8% returns) | Rs. 2,15,892 |
| Post-tax corpus at the end of 10 years | Rs. 2,04,303 |
Considering the long-term capital-gains tax at 10%
2. You can redeem your money from this scheme, pay the capital-gains tax applicable and invest in a better-performing scheme. Let’s say the better-performing fund gives an annualised return of 12%. At the end of 10 years from buying the first fund, when you finally redeem the second one, your corpus will be as follows.
| Initial investment amount | Rs. 1,00,000 |
| Total amount after staying invested for 3 years (8% returns) | Rs. 1,25,971 |
| Post-tax corpus after 3 years | Rs. 1,23,374 |
| Total corpus at the end of the 10th year (12% returns) | Rs. 2,70,740 |
| Post-tax corpus at the end of 10 years | Rs. 2,57,804 |
Considering the long-term capital-gains tax at 10%
So, from the above, it’s clear that you can just sell the poorly performing fund, pay the tax, and invest in a more deserving fund. This strategy can lead to a higher corpus and will also eliminate unnecessary funds from your portfolio.
2. Exit Sectoral and Thematic Funds
Many investors end up investing in sectoral/thematic funds based on their short-term performance. However, these funds are often not suitable for an average investor as they provide limited diversification and can be very volatile. If a sector/theme is appealing, your regular plain-vanilla fund would also invest in it, thus providing you with the necessary exposure.
The chart below shows the volatility as measured by the standard deviation in the five-year daily rolling returns over the last 10 years of some sectoral categories vis-a-vis flexi-cap funds. Most sectoral fund categories tend to be more volatile than simple flexi-cap funds.
Standard deviation based on five-year rolling returns. Based on the category average. Data from April 1, 2013 to April 1, 2023.
3. Assess The Need for Mid/Small-Cap Funds
Mid/small-cap funds are more volatile and riskier than plain-vanilla flexi-cap funds. Only those who are willing to take extra risk for extra returns should invest in them, that too for no more than 30% of your portfolio. If you don’t want to take extra risk, you can exit the mid/small-cap funds in your portfolio. If you do want them, ensure that you are not going overboard with them.
The chart below shows the standard deviation of five-year rolling returns of small-cap funds, mid-cap funds and flexi-cap funds. While mid- and small-cap funds may have a better return profile than flexi-cap funds, they also have higher volatility.
Standard deviation based on five-year rolling returns. Data from April 1, 2013 to April 1, 2023
4. Ask Yourself Why You Invested In Large-Cap Funds
Large-cap funds are meant for conservative investors who want an equity kicker in their portfolio but are not willing to take much risk. For most investors who want to build wealth with equity funds, flexi-cap funds, which can invest in companies of all sizes and in any proportion, are often the better choice. So, unless you have a good reason to invest in large-cap funds, you can exit these funds.
The following table shows five-year rolling returns of the large-cap and flexi-cap categories.
| Scheme | Average 5Y rolling returns (%) |
| Large-cap funds | 12.35% |
| Flexi-cap funds | 13.17% |
Five-year rolling returns from April 1, 2013, to April 1, 2023
5. Are You Too Heavy On Debt?
Indians’ love for debt instruments is well-known. If you have multiple debt funds in your portfolio for no good reason, it’s time to exit them. Debt funds are needed for the fixed-income component of your portfolio. How much-fixed income you should have in your portfolio depends on your asset allocation. If you have more allocation to debt than that, it may be time to relieve yourself from some debt in your portfolio. Do remember that while checking your debt allocation, include your small-savings schemes (such as the PPF, Sukanya Samriddhi Yojana, National Savings Certificates, etc.), bank fixed deposits, recurring deposits, and other fixed-income products.
6. Do You Need to Go Hybrid?
Hybrid funds invest both in debt and equity and provide automatic asset allocation. Balanced advantage funds, a type of hybrid fund, are appropriate for beginners as they allow the fund manager to dynamically adjust the asset allocation to optimize risk and return.
If you invested in hybrid funds for some specific reasons, it’s okay. However, if you invested in them without any prior thought, it may be time to assess if you need them in your portfolio, especially when you have equity and debt funds in your portfolio as well.
7. Check For Portfolio Overlap
Portfolio overlap happens when the schemes in your portfolio have a large percentage of overlapping holdings. So, while you may be holding separate funds at the security (stocks, bonds, etc.) level, they are kind of duplicates. You can simplify your portfolio by exiting the duplicates.
8. Realign Your Portfolio With Your Goals
A person’s portfolio should be aligned with their financial goals, which could be short, medium, or long-term in nature. Analyse your goals and desired asset allocation and then build a model portfolio. Now see the gap between your existing portfolio and the model portfolio. Remove the funds that won’t help you with your goals.
9. Use ET Money Portfolio Health Check
ET Money offers a free portfolio health check tool. You can use it to identify what’s wrong with your portfolio. This information can also help you exit undesirable funds.
Conclusion
When it comes to mutual fund investing, simplicity is key. Just ask yourself why you started investing in mutual funds. You probably did so because you wanted to earn good returns but also didn’t want to invest in stocks or bonds directly. Ultimately, you wanted simplicity combined with reasonably good monetary outcomes. By investing in too many funds, you may be unintentionally working against this goal. It’s time you think about it.
