Mutual Funds & Diversification: The Overlap Trap

You might think adding more mutual funds to your portfolio automatically makes it more diverse, right? Turns out, that’s not always the case, and you could actually be concentrating your investments without realizing it.

Rhishabh Garg, CEO of FundsIndia.com, explains that simply holding many funds doesn’t reveal much about how diversified you truly are. Individual mutual funds often contain 40-60 or even more stocks, and different schemes can share similar underlying holdings and strategies.

True diversification comes from combining assets and strategies that don’t move in sync, such as:

• Growth, value, or quality funds
• Mid and small-cap funds
• Funds offering global exposure

The Overlap Problem: What the Numbers Show

Amitabh Lara, Executive Director at Anand Rathi Wealth Limited, highlighted this issue after auditing roughly 13,600 mutual fund portfolios. His study revealed that many investors believe they are diversified, but their holdings tell a different story.

Key Findings from the Audit:

• 16% of portfolios underperformed the Nifty 50.
• A significant 86% underperformed the firm’s model portfolio.

Lara gave an example of a hypothetical portfolio with seven supposedly diverse categories, like large-cap, flexi-cap, and focused funds. This portfolio still showed a heavy tilt towards large-cap stocks, with large-cap funds having 82% large-cap exposure and flexi-cap funds nearly 60%.

Watch Out for Sector Concentration

Sector concentration poses another significant risk you need to be aware of. If you combine funds like SBI Large and Mid Cap, HDFC Flexi Cap, and ICICI Prudential Focused Fund, you might find banking is the top sector across all three.

Imagine investing ₹1 lakh in each of these funds; this could result in 27-30% of your total portfolio being concentrated in the banking sector alone. This means a downturn in banking could impact a large chunk of your investments, even if the individual stocks are different.

How to Diversify Effectively

There’s no magic number for how many funds you should hold; it really depends on your portfolio size and investment strategy. Garg suggests that smaller investors begin with just two or three funds that offer genuinely distinct exposures.

A clear sign of over-diversification is when you can’t explain what unique value a particular fund adds to your portfolio that another doesn’t.

To ensure you’re truly diversified, experts recommend regularly comparing your portfolio’s performance against a suitable benchmark. You should also meticulously review the underlying exposures of your schemes to understand what you truly own.

Remember, effective diversification is about the unique market-cap, sector, asset-class, or investment-style exposure each fund brings, not simply the quantity of funds you own.