Avoid Over-diversifying in Mutual Funds

It is common knowledge that Mutual Funds provide an avenue to diversify your equity investments across multiple stocks. Diversification raises different opinions in the investment community. In the words of Warren Buffet,

Diversification is for fools! If you understand what business and the company you are betting on, you will have stronger focus and conviction on a few.

I am no one to even remotely challenge that. I can though speak from the lens of a majority of retail investors who do not have the propensity to go that extra mile to track the business closely. And that is why most of them choose the mutual fund route.

The problem is not with diversifying, but taking a step too much and believing diversification on top of diversification works even better. First of all, one needs to understand why we diversify. To spread out the risk of investment of course. And for mutual funds, the lowest unit of underlying investment is company stock. If you keep this point as the center of strategy, it translates to having some level of visibility around which stocks these funds are mapping into.

Mutual funds categories span across Large Caps, Mid Caps, Small Caps, Flexi Caps, and others. A common mistake that investors make is picking just too many funds from each of the categories where each fund is effectively tracking a very similar underlying equity. Various tools at your disposal make it easy to visualize the investment overlap between 2 funds. Advisorkhoj and TheFundoo are some of them that will help you get this information.

Here is a snapshot from one of such tools that provides a great view of how many redundant investments you would make if going with both funds.

Leverage this metric to analyze your fund investments and cut down on too much fund diversification. There is no right answer to how many funds you should invest in. It depends on the underlying equity distribution and how comfortable are you with that portfolio. Even one can argue that multiple similar performing stocks in same sector may be an overdone diversification.

Investors at times diversify across funds because some funds underperform within a certain duration. There could be bad eggs in the portfolio, and as is the nature of equities, some of the stocks’ performances are cyclical, and the funds reflect the same. Many times investors get impatient, check the trailing return of last year for the high-performing fund, and switch to that. A good example is how you switch queues seeing the other queue is moving fast, and suddenly that queue slows down! Such a strategy never works in long run. Stick to your bets for a longer term, unless you read something discomforting about the fund management itself.

The comparison tools may not surface a complete picture of the percentage of underlying equity investments. For example Fund A and Fund B both might be investing in Stock X. But Fund A just has 2% of its portfolio exposure to it, whereas Fund B has 5%. I wouldn’t recommend investors to bother too much about it; else you would be better off doing direct stock investments. But just thought of calling out this point that the overlap degree may not be that apparent from all these fund tools. Having said that, if you are curious to know about the underlying stock distribution of your funds, I have a recommendation for an useful tool just for that purpose!

Try out the Morningstar Instant X-ray tool wherein you can record your absolute investments in each of your mutual funds. It will then give your top 10 underlying stock distributions. Here are the steps to do it: