Diversification: How many schemes?

I have come across many investors who have invested in a range of mutual funds, in the name of diversification as well as risk mitigation. More often, I find that many investors develop a mental block and keep a financial limit on a single scheme. For instance, an investor has a limit of Rs5 lakh for a single scheme. His portfolio is in excess of Rs3 crore and he has ended up having investments across 60 schemes! I tried talking him out of it but his response was that this was his way of managing risk.

Most of the stocks would be common across the schemes and the end result would be around 40 to 60 stocks taking up more than 70% of the portfolio value; the balance 30% would perhaps be spread across another 100-odd stocks. An investment in a single large diversified equity fund would perhaps have produced the same mix of equities! I shudder to think of the pain of managing 60 accounts with various mutual funds.

Any mutual fund manager would strive to achieve diversification in each of his given funds. Concentrated bets are more the norm in sector funds or theme funds. In fact, if we exclude sector funds, the SEBI (Securities and Exchange Board of India) guidelines limit investment in a single stock to 10% of the scheme’s total assets under management (AUM). In effect, the guidelines themselves are designed to give you a minimum of 10 stocks in any portfolio.

Diversification distributes my risk. But I am against diversification simply for the sake of diversification. I resort to diversification for some part of my portfolio. For me, investments include land, gold, stocks and fixed-income securities. But remember that there is also a risk that all investment classes may perform badly at any given time. In a depression or a slowdown, everyone tries to be ‘safe’ and runs away from real estate, stocks, bonds, etc. Even gold may not find buyers. It is theoretically possible.

If you do not like focused or concentrated bets within the mutual fund space, try and limit your funds to two or three. In any case, if you are a compulsive diversifier, a spectacular show in one particular fund would hardly amount to a dent in your overall investment portfolio. So, whichever way you look at it, diversification beyond a point is needless. Of course, you will curse me if the fund house you choose turns out to be the worst performer, going forward. I have no crystal ball to tell which fund to choose. I go by reputation and integrity of a fund house (that too is getting to be a relative affair, with fund houses constantly being found guilty of some malpractice or the other), its track record (I know, the past is no indicator etc, etc; but I still find it useful) and the longevity of the fund manager. As a rule, I keep away from sector funds. I think that they get launched at the peak of a sector’s performance and, in any case, I am unlikely to put all my bets on a single sector.

As regards real-estate investment, I tend to go directly for the asset class rather than the mutual fund or the PMS (portfolio management service) route. Of course, if the resources available do not permit one to be in this asset class, it is best to avoid it rather than chase stocks in the real-estate sector. If your wallet size is not large enough and you do not have enough patience, real estate is not for you. So, to limit my number of mutual funds, what I would do is to choose the best funds over the past five to ten years and pick two or three out of the top five.

Diversification of wealth among asset classes is an important facet of risk management. However, remember, increasing the number of equity mutual funds does not mitigate or minimise risk. What I achieve by investing in a single large diversified mutual fund would be the same as what I would achieve by distributing it across 20 different schemes that claim to be diversified.

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