The simple answer to this question is that we need to diversify our investments. By investing in mutual funds, we get the services of a professional fund manager. He/ She is able to pick the right investments for us. Moreover, although the amount of money we invest is small, sometimes even as low as Rs.1,000, we get the benefit of investing in shares of different good quality companies.
For example, if I invest Rs.1,000 in ICICI Prudential Value Discovery Fund Direct plan, your Rs.1,000 enables you to own 40 stocks, including L&T and HDFC Bank, whose share price (of 1 share) is more than Rs.1,000. This is because the fund manager is managing a large amount of money( Rs.17,300 crore plus as on May 31, 2017) and can afford to spread the amount across different investments.
Secondly, Regulation forces the fund manager to invest in different securities. Thus, one clear benefit of investing in Mutual Funds is to get the benefit of diversification.
What can go wrong with Mutual fund investments?
We have repeatedly come across the statutory warning of “mutual fund investments are subject to market risks. Please read the offer document carefully before investing”. What does this statement really mean? It means that although a professional fund manager is managing your money, he or she does not provide any guarantee that you will get any assured returns on your investment. Your investment value may go down, resulting in a notional loss to you.
What it means is that the fund manager can go wrong with his choice of investments, just like you and I can. However, because of the regulatory requirement that the fund manager has to necessarily spread the investments, the impact of the fund manager’s wrong choice is likely to have a lesser impact than the impact of a mistake committed by us.
Thus, investments in mutual funds, particularly in equity mutual funds, can result in a loss. However, because of the benefit of diversification, the impact of such a loss on us gets cushioned.
So, should I invest in only one mutual fund scheme?
To answer this question, we again go back to a more basic question. Why am I investing? I have emphasized in my earlier blogs also that investments need to be made based on our financial goals and not for the sake of investments. Thus, a goal based investment plan will result in a portfolio of various financial assets such as gold, equity, debt and liquid assets. Obviously, one fund will not be able to meet this requirement. Based on your portfolio allocation, you should ideally hold multiple mutual fund schemes across various asset classes. So, your portfolio will contain equity mutual fund(s), debt mutual fund(s), liquid fund(s) and Gold fund(s). One mutual fund is unlikely to ideally replicate the requirement of our portfolio.
How many funds?
We are now back to our original question. How many funds should I own? Should one fund under each asset class suffice?
Although our portfolio allocation will have a mix of each of these asset classes, we need to recognize that there are various sub-asset classes within an asset class. For example, within equity, we have Large Caps, Mid and small Caps, Thematic funds, ETFs, Tax Saving Funds, etc. Thus, our portfolio allocation should not stop at the asset class level, but should drill down further up to the sub-asset class level. Your Risk profile can determine the composition of funds at the sub-asset class level that you should be holding. Holding one fund does not help. We need to invest in multiple funds, based on our portfolio allocation.
What if we end with an under-performing fund/ fund manager?
This can always happen. Sachin Tendulkar (or Virat Kohli for today’s generation) may be a great player but we cannot expect him to score a century in every match. We may not be personally impacted if a batsman fails to score runs, but we will be impacted if a fund manager fails to perform. Hence, it may not be a bad idea to go with 2 fund managers. In other words, choose two different funds under each sub asset class. Again, to illustrate, if the portfolio allocation recommends investing 20% of the funds in large Cap Equity, it may be a good idea to invest 10% in say, ICICI Focussed BlueChip equity Fund and another 10% in HDFC Top 200 Fund (this is not a recommendation. The names of the funds have been stated for illustrative purposes only). I do not see any point in choosing three, four or more funds within the same sub asset category, except in some very specific situations.
Same AMC?
I do not have a problem with 2 funds being selected from the basket of funds offered by the same AMC. However, the fund managers of the two schemes should be different and also work independently of each other. More often than not, this is not the case. Hence, it is advisable to choose 2 funds from 2 different AMCs.
Should I do this for all sub-asset classes?
This strategy of choosing 2 funds under each sub-asset class can be applied for all actively managed funds. However, in case of funds that are passively managed, there is no point in diversifying across 2 funds. This is because, in case of passive funds, there is no role of the fund manager. For example, to the extent your portfolio allocation recommends an investment in Gold, investing in one gold fund is good enough. All gold funds, being passive, will have an identical performance.
Conclusion:
There is no magical number of funds to own. It depends on your goal based portfolio allocation at the sub asset class level. Within each sub asset class, for actively managed funds, choose two funds across different Asset Management companies and in case of passively managed funds, choose one fund. Of course, consulting a Registered Investment Advisor to specifically plan a portfolio for you would be the best thing to do. One thing that should not be forgotten is to invest only in Direct Mutual Funds.
For more info check here on how to invest in direct mutual fund platform
