How to build a diversified mutual fund portfolio

Diversification refers to the simple common sense, ‘not to rely too much on one entity’. In this post, I discuss simple ways to build a diversified portfolio using mutual funds.

The main purpose of diversification is to minimise losses, or rather the volatility in the portfolio value. This implies reducing exposure to an asset class with ‘potential’ to offer high returns.

Step 1: Decide on the investment strategy. Are you going to invest systematically, time the market etc. I dont know which is better and I dont care. All I know is that we need to do what is suitable for our temperament.

Step 2: Decide on the percentage exposure to equity, fixed income and any other asset class that you are comfortable with. This is referred to as asset allocation. There many asset allocation strategies. I shall cover these in another post. For now, let consider a simple plan: 60% equity, 40% fixed income. This automatically means that we are planning for a long-term goal: Equity investing: How to define ‘long-term’ and ‘short-term’

Step 3: Recognise that the percentage allocations mentioned above will change on a daily basis due to fluctuations in market value. We need to rest the allocation back in line with our plan from time to time. This is referred to as rebalancing. I had written about this earlier, but will revisit this area in another post.

Step 4:  Diversification refers to two distinct processes (a) diversification across asset classes – equity, fixed income, gold (if comfortable) etc. and (b) diversification within an asset class. It is this part that we shall focus on in this post.

Step 5: Decide on fixed income strategy. Some investors (me too) prefer rock-solid fixed income and prefer to have volatility in equity alone. So for long-term goals, the natural choices of fixed income instruments are EPF, VPF, PPF – tax-free fixed income.

For goals where such instruments are not suitable, debt mutual funds can be an option. Here again, I would recommend not to diversify across debt fund categories and low volatile ones like liquid funds, ultra short-term funds or (ultra) short-term gilt funds: How to choose debt mutual funds with no credit risk and low volatility. Some people refer to have some tactical exposure to long-term gilt funds.

Step 6: Building a diversified equity portfolio. This can be with 100% direct stocks, 100% mutual funds or a mix of the two.

It is probably easier to build a diversified direct equity portfolio by picking stocks across sectors. When it comes to mutual funds, most portfolios (including mine) are a mess because we buy funds without thinking too much about diversification and the importance of a minimalist Portfolio. Cluttered portfolios can be rectified gradually with a clear plan.

I would like to give you an explicit example of building a minimalist equity portfolio. The minimum number of funds necessary to do this is just one (at least for young earners)!

As long as you need the 80C tax break, a single ELSS fund will give you the necessary diversification. No other equity fund is necessary.

Or you can use your expenses + EPF+ PPF for 80C and not use ELSS funds. This is probably a better strategy.

A simple investment strategy is one-large cap fund + one mid/small- cap fund. Just two funds.

One can also consider just a single multi-cap fund or a single balanced fund and treat it as pure equity.

Examples of the two-fund strategy.

(a) Hunt for a pure large cap fund or any fund that has a strategy to stick to the top 50 or 100 stocks by market capitalization. This typically means funds which can pick from the BSE 100 index.  Almost every AMC has a fund which fits the bill and they are often named ‘top 100’.

Examples: Frankin Blue Chip, DSP Top 100, Birla top 100 etc.

(b) Hunt for a non-large cap fund. That is funds which will not invest in the top 100 stocks by market capitalization. For example. Mirae Asset Emerging Blue Chip has such a mandate. Other funds which generally do not hold large cap stocks, Franklin Prima, IDFC premier equity, UTI mid-cap etc. It is easy enough to find out in the Value Research Mid-cap category listing.

There is no evidence that AUM impacts fund performance. However, size of the fund matters for style purity. Large the AUM, more would the large cap exposure. So smaller funds which no one is talking about would be better.

Investors exhibit a lot of herd instincts. So it is quite easy to spot quiet but consistent performers.

That is it! You now have two funds which can give you the diversification across market caps.

Diversification across sectors. This is a bit trickier can change a lot depending on market conditions.Most portfolios tend to be overweight on the financial sector.

If this is important to you then, shortlist a few funds based on market cap. Create an account with a portfolio manager like Value Research and enter some dummy transactions with those funds. The analysis tab will give you detailed insights.

For example, this is  a dummy portfolio with 50% investment in PPFAS and 50% in Franklin Blue Chip.

portfolio-diversification-2 portfolio-diversification-1

Such a two fund portfolio is reasonably diversified across both market cap and sectors (a bit too much on financials -a common problem). Without too much analysis, I would settle for such portfolio.

Step 7: The last step is to decide allocation to large cap and the mid/small cap fund. I would recommend 60%-70% large cap for new investors. After a few years, they can decrease large cap exposure. but I would suggest not going below 50%.

This is the first in a series of simple portfolio management steps. If you have any post suggestions, I am all ears.

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15 thoughts on “How to build a diversified mutual fund portfolio

  1. We often forget that PF is part of our debt portfolio, hence no need to focus on other debt avenues.
    Another diversification we try to do is across fund houses and as the investments get bigger we feel safer with more funds. In no time we will have about 10 funds. Then downsizing becomes difficult as there is no Switch option across fund houses; withdrawing and reinvesting is tedious, hence maintain the status quo of 10 funds.

  2. “I dont know which is better and I dont care. All I know is that we need to do what is suitable for our temperament.”

    That is such a great piece of agnostic advice.

  3. I have a suggestion. Instead of 1 large cap n 1 small cap fund. i would recommend 2 of each or 1 large .1multicap and 1small cap fund.

    I am investing in UTI Opportunities since 4 yrs and it has been under-performing since all those times thereby giving me negligible returns.

    if this returns continue and this is my only fund , then corpus generated will be much smaller than expected.

    Luckily I have another large cap fund along with this. Although there is an overlap , my overall returns is not impacted by under-performance of one fund.

  4. Hi Pattu,
    Something is not right at step 6. A 50% portfolio containing each of PPFAS and Franklin India Bluechip invested on 29th Apr, 2016 would show Alphabet Inc as the top holding. Not sure if that affects your analysis though.

    That said, thanks for the post and as you are “all ears” – here it goes (and this is strictly for the Mutual Fund portfolio part of it):
    How do we make sure that we have manged returns commensurate to the mix of funds contained in the portfolio? In other words – it is relatively easy to see performance of a single fund on various parameters and take an investment call on it, but the assessment game totally changes when it comes to portfolio management.
    How do we keep nudging towards a mix that keeps increasing the return/risk ratio of the overall portfolio?


    1. Hi Anand, that is just a screengrab from VR. Maybe there is a mistake. Does not change much wrt the post though. If you see my revised How to review a mutual fund portfolio post, I would have mentioned about this nudge in terms of returns. Risk assessment is a difficult ballgame. Will see what I can do about it. Thanks.

  5. The suggested frame work to diversify MF portfolio is indeed ideal, except step 6 where stocks also come into picture which complicates monitoring on a regular basis. Often we notice some funds have similar exposures but performances vary, simply for the reason of varied price points of purchase and holding periods, nature of holdings – be it on month end books or expiry series basis or even a trading bet, at that specific point in time. To my mind this apart, it is indeed a shopping list for diversified MF portfolio and of course no. funds to add could again vary based on ones comfort level and size of holding which dictates amount of monitoring.

    The simpler ( but not necessarily better) way to compare and measure performance & risk parameters of mutual fund schemes could be by comparing them with their benchmarks, rather than their peers which indirectly implies we are looking to compare or chase relative performance. Request learned Freefincal readers to suggest sources which list out all the equity funds along with performance and risk data, based on a select benchmark. Similarly sources or tools which sort & list out equity funds with percentage exposure to a select Industry or sector, which can be very useful if some one has a flair or inclination for an enhanced exposure towards a select sector for some period , but not to the extent of a pure sector fund.

  6. Pattabhiraman Sir: like many who have gone on record, even I feel really amazed to the levels of passion and motivation you hold towards personal finance and your thought processes to bring it all down to numbers and plots. It is all the more surprising to the amount of time you devote apart from your regular profession of teaching. To be frank and true, more than the numbers I visit Freefincal for some incisive and out of the box inferences and observations which ignite reader opinions and interactions., all for common benefit and learning. Unfortunately though I attended your Hyderabad workshop my take aways were not so much, mainly due to paucity of your time and also to satisfy needs of varied spectrum of investors while sticking to your subject.

  7. As the beginner in financial studies ! i really like the way you have described all that. From the starting of step one to step 7; i really like the way you have described all that.

  8. As far as large caps MFs, most likely one or two are ok (since most / major holdings of large funds are almost same except few). But for mid caps, when I checked the holdings, they vary much. Is not advisable to have more based on the size of the portfolio so that it will help volatility and also returns? Thanks

  9. Dear Sir,

    I dont have much knowledge in mutual funds. I have about 5 lacs amount of cash in FD. I want to invest in MF. Kindly sugguest some MFs.

  10. Sir I already invested in equity MF.. now I want to invest in debt MF’s, I am confused with different categories under debt MF’s. Can you pleas tell me about pure debt funds with minimum or no risk category? And where I can get these information?.

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