A subscriber to our YouTube channel asks, “How many equity funds are required for adequate diversification?” At first glance, the answer seems easy, but it is not. Diversification can refer to diversification across asset classes like equity, fixed income, gold, and real estate or diversification within an asset class. We believe the subscriber refers to “within an asset class”, like equity or fixed income and shall address that.
Many readers expect a technical answer to this question. Sadly that is not practical. Considerations here are subjective and depend on the comfort level of the investor. What does diversification within equity mean? There are two ways to accomplish this. We can spread across sectors or spread across market capitalization.
Suppose I choose a Sensex index fund. I get 30 stocks diversified across sectors but within the large cap universe. Is this enough diversification? Yes, we think so. An equity portfolio can have just one Sensex index fund until it is small.
Once the portfolio grows, it is natural to feel uncomfortable about investing with just one AMC and adding one or two funds. This is entirely up to the investor. I know investors who hold crores in a single fund and others uncomfortable beyond a few lakhs. This diversification addresses concentration risk or the fear of concentration risk.
Many investors incorrectly believe (without meaningful data support) that including mid caps and small-caps in the portfolio is essential for diversification as the reward would be higher over the long term. Much of mid cap and small cap fund purchases are often driven by a fear of missing out but are often labelled as “diversification”.
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The problem with this approach is the risk is guaranteed, and the reward is not. Someone who insists on mid cap and small cap flavours is better off with a single flexicap fund (not a multicap fund!) that invests in a little bit of mid and small cap stops while being predominantly large cap oriented.
Although this would mean choosing actively managed options, the hassle of managing the weightage of each market cap segment is left to the fund manager and the associated tax and exit load burden is removed. There are passive options like the Nifty large midcap 250 or Nifty 500 index, but the hassle of tracking such a large number of stocks can result in tracking errors.
I once asked investors how to determine the impact of portfolio diversification, and most responses were wildly off the mark. So I am convinced that most actions in the name of diversification only result in clutter. Then such portfolios begin resembling index funds with a large expense ratio.
Counterintuitive as it may seem, the number of funds should be kept as small as possible for diversification to work (at least until the portfolio size is small). A single Nifty/Sensex index fund will do for those who prefer passive investing. If they are a bit more adventurous, they can consider Nifty Next 50.
For those who prefer actively managed funds, a flexicap fund, an aggressive hybrid fund, or a multi-asset fund will get the job done.