How to build a diversified mutual fund portfolio

Published: April 30, 2016 at 7:52 am

Last Updated on May 27, 2021

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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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations based on money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association, IIST Alumni Association. For speaking engagements, write to pattu [at] freefincal [dot] com
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