The Hindu Business Line : How many funds should you hold?

Investors like to hold a number of mutual funds in their portfolios in the name of diversification. A typical portfolio would, hence, have exposure to several diversified funds, style and sector funds. But as one reader asked us: Is holding several mutual funds optimal?

This article discusses concentrated portfolios. It explains what a concentrated portfolio means within the core-satellite framework and shows why it is optimal to have just a handful of funds in a portfolio.

Defining concentration

Our discussion of concentrated portfolios is framed from an investor’s perspective. It, hence, means number of mutual funds or stocks that an investor holds in her portfolio.

It is important to understand that concentration does not refer to the number of funds in a portfolio. Rather, it refers to the exposure that the investor has to each fund.

Investor A may have five funds in a portfolio with one fund constituting 80 per cent of the total portfolio of Rs 25 lakh. Investor B, on the other hand, may have just two funds with equal weights. We can conclude that Investor A has a more concentrated portfolio than Investor B even though the former has more funds in the portfolio.

The question is whether it is optimal for investors to have a number of funds in their portfolio.

Equity core

Within a core-satellite framework, the preferred exposure to equity core is an index fund benchmarked to the broad market index or large-cap style index. Based on the producing offerings in the market, an exposure to an index fund benchmarked to the S&P CNX 500 or S&P CNX 50 or the BSE Sensex would be in order.

Take the funds benchmarked to the Nifty index. All of them carry the same portfolios. So, what then is the rationale in holding three such funds?

Investors would rather buy just one index fund of their choice to construct the equity core. Buying more than one fund amounts to fund diversification not portfolio diversification. And that could be justified only if the investor is concerned about the credit risk of the asset management firm.

Equity satellite

The satellite portfolio is set-up to beat the benchmark index. This portfolio could carry mid-cap, small-cap style funds and sector funds. Carrying direct exposure to equity is also optimal.

Unlike equity core, the equity satellite portfolio carries exposure to active funds. And since no two active funds carry the same stocks, it is, indeed, tempting for investors to hold large number of funds under each style universe.

An investor, for instance, may hold Sundaram BNP Paribas Select Focus Mid-cap Fund, DBS Chola Mid-cap Fund and Birla Sun Life Mid-cap Fund under the mid-cap style universe. But is it necessary to hold several funds in each style universe?

It would be optimal to hold not more than two funds in each style universe. Why two? Taking a single fund exposure to each style universe may be perceived as too risky. Taking exposure to more than two funds will not lead to any substantial benefit, as style funds invest within the same universe of stocks.

With sector funds, the universe of investable stocks is small. It is, hence, optimal to hold just one fund in each sector.

Conclusion

A typical core-satellite portfolio would have one fund in the equity core and not more than three funds in the equity satellite. Many investors have questioned the structure, as it is appears concentrated.

But holding several index funds and style funds does not necessarily lead to diversification. So, rather than be concerned about the number of funds in a portfolio, investors would do better to analyse if adding more funds in the same style universe is beneficial. Often it is not, as peer funds chase the same universes of stocks. Besides, it is easier to monitor a portfolio that has fewer funds.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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