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The curious case of how many funds you should hold in your portfolio

While there is no one-size-fits-all approach, the number of funds one can have in the portfolio would differ as per the goals and risk profile of investors.

Jan 2023

4 mins read

Our wardrobes may be filled with clothes/shoes for different occasions. If we take this analogy in the context of our investment portfolios, do we need a fund for every season and market cycle?

Over the course of our investment journey, we may end up investing in multiple funds which may look attractive at that point of time or just because they were recommended by a relationship manager/friend/colleague, etc.

The mutual fund industry offers a plethora of fund categories. To be precise, there are more than 1,400 mutual fund schemes as of February 2023. So how many funds you should ideally hold in your portfolio?

When we construct portfolios, diversifying across asset classes like equity, debt, currency and commodities is the thumb rule. But how many funds should you own within these asset classes to truly diversify?

Beginners

For investors who are new to mutual funds and can’t decide their asset allocation mix, Hybrid Funds can be a good fit. Hybrid Funds offer a variety of options to suit different risk profile which can be a good starting point for new investors and help them achieve the benefit of diversification (equity, debt and gold) without having to worry about choosing from a variety of funds from other categories.

Choosing active and passive strategies

Passive Funds aim to mimic an underlying index while active funds aim to outperform the benchmark.

You can invest in two actively managed Large Cap/Mid Cap/Small Cap Funds. However, investing in 2 Index Funds/ETFs tracking the same index, say Nifty 50 or BSE 100 or Nifty 100 may not serve the purpose of diversification. This is because both index funds/ETFs tracking the same index will deliver more or less similar return.

Why should you invest in more than 1 fund in case of actively managed category is that they can protect the downside (when market falls) or deliver higher than the benchmark. The performance of 2 funds within the same category (actively managed funds) can differ widely.

Performance of Nifty 50 ETF

For instance, ETFs/Index Funds tracking Nifty 50 Index have delivered around 0.40% over a one-year period as of March 31, 2023.

Performance of Actively Managed Large Cap Fund

Over a one-year period as of March 31, 2023, the top performing actively managed Large Cap Fund has delivered a positive 7.45%. At the other end of the spectrum, the bottom performing actively managed Large Cap Fund has delivered negative -6.47% over the same period. Why is there such a divergence in return in the actively managed category?

This is because actively managed funds aim to outperform their benchmark. For instance, A Large Cap Fund can take underweight or overweight position in the 100 stocks which form a part of the Large Cap index. Actively managed funds may hold say only 50 stocks out of this 100 stock basket. On other hand, an Index Fund or ETF will aim to hold all the securities in the index in the similar weight as per the index. Thus, the returns of Index Funds and ETFs will be in line with the benchmark return.

Thus, a passive fund can complement your portfolio but they are not mutually exclusive. You may need both active and passive in your portfolio.

Gold/Silver

Investing in one Gold/Silver Fund should suffice. Adding another fund in this category would not be fruitful since the underlying asset class is similar.

Holding overlap

Owning too many funds may not help you achieve diversification beyond a certain point. While selecting funds from a particular category, it is ideal not to invest in too many funds. This is because funds typically tend to hold similar stocks. This can be ascertained by taking a deeper look at the holding overlap of your existing funds. If there is a high overlap, few funds can be pruned and others could be added. Do note that the portfolios of mutual funds change based on the fund manager’s outlook on a sector/stock/valuations/macro-economic conditions/changes in index composition, within the contours of the investment mandate of the scheme.

Diversification across market cap

When picking Equity Funds, you need exposure to Large, Mid and Small Cap. The extent of exposure toward each of these market caps would depend on your risk appetite.

To diversify across market cap, you have multiple categories: Flexi Cap, Multi Cap, Large & Mid Cap. There could be multiple approaches:

You can either take a dedicated exposure to each market cap through three different funds – Large, Mid and a Small Cap Fund or;
The second option is to invest in a Flexi Cap Fund where the allocation is spread across all market caps depending on the fund manager’s discretion.
Multi Cap Fund is another option where the exposure to Large, Mid and Small Cap is fixed at 25% each, respectively.

Style

Growth and Value outperform each other during different market cycles. Growth tends to do well during an economic expansion while value stocks tend to shine during a downturn. It can be difficult for most retail investors to predict when each of these styles will play out. Hence, it is advisable to have exposure to both styles or a blend.

What do they mean?

Growth

Growth investing entails investing in companies that have exhibited high growth in earnings/revenues/sales in the past and are expected to continue growing at a similar pace going forward. Such companies may command a higher Price to Earnings Per Share (P/E).

You can ascertain a fund’s style by looking at the Style Box which can found on websites like Morningstar and Value Research, among others.

Value

This means fund managers invest in stocks that are trading below their intrinsic value. It involves a contrarian view where managers buy stocks of companies that might be facing temporary headwinds but their long term prospects may look intact.

The above style box indicates the fund follows a Blend style, which is a mix of growth and value. (Image Source: Morningstar)

Diversification across Fund Houses

Each fund house is guided by its internal fund management style, processes and risk management measures. Just like a singer’s voice is unique, each fund manager brings with him/her a unique investment perspective, style, experience and qualifications. While choosing funds, it is ideal to spread your investments across fund houses.

How to approach sector funds

Sector funds can deliver outsized returns during a upcycle and at the same time can be negatively impacted when the tide turns against the sector. It is important to understand that a sector fund can only invest in one sector as per the investment mandate of the scheme. It can be Technology, Infrastructure, Banking, FMCG, etc. No single sector can outperform every year. For instance, PSU Bank Index was the best performing index, clocking gains of more than 72% in calendar year 2022. On the other hand, after a spectacular run in 2020 and 2021, IT Index lost -25% in 2022. Thus, sector funds should ideally not form the core part of your portfolio. One can invest in a sector fund if one can get the entry and exit right or if someone is looking for a exclusive allocation to a sector.

Debt Funds

A healthy mix of equity and debt protects the portfolio from downside during a correction. Debt Funds can help you save for short and medium term goals. Debt Funds can be tactically used to hold cash to stagger your investments in equity funds when opportunities arise or book profits. You can select funds in from the short, medium and long duration category depending on your investment objective, goal and risk appetite. It is important to diversify across fund houses in categories of funds which have high credit risk and interest rate risk. It is advisable to consult a financial advisor while picking Debt Funds as they are impacted by a number of factors like interest rates, inflation, economic growth etc.

Summing up

While there is no straightforward answer to this question, the fewer funds you own (which takes care of your asset allocation and diversification goal), the better it is to manage, track and make course correction.

The number of funds should be enough to provide adequate diversification across style, market capitalization, geography and asset class which could take care of your short term and long term goals. Some investors can hold fewer funds but others might a larger set of funds across categories once their investment ticket size increases.

While there’s no one-size-fits-all approach to building portfolios, the number of funds and the percentage of allocation to each fund based on market cap, style and geography would depend on your life cycle, risk appetite and goals.

It is advisable to consult a financial advisor can help review your portfolio.

Key takeaways:

Sector funds can be considered for tactical or exclusive allocation to a sector.
Checking holding overlap helps you prune your portfolio.
Diversify across market cap, asset classes, style, AMC, and geography and risk profile of the scheme.
Invest in a mix of growth and value oriented funds.

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