Photo courtesy Anna Nekrashevich.
Mutual funds offer a better return on investment than the fixed deposit. The number of people investing in mutual funds is ever-increasing due to the low-interest rate scenario. It is good for people to invest in mutual funds but with no other comparable alternative people try to diversify across mutual funds and in the effort to have 15-20 funds in their portfolios.
Having too many mutual funds is not good for the portfolio. This is not just diversification but over-diversification as a single mutual fund itself is invested in 50-70 stocks. In many cases, there is an overlapping of the stocks in portfolios.
How many mutual funds should a person have in their portfolio?
There should be 2 large-cap mutual funds in your portfolio. The number of the mid-cap and small-cap should also be 2 each in the portfolio. There is higher volatility in the mid-cap and small-cap funds though they provide higher returns. Don’t have overexposure to midcaps and small-cap funds just for higher returns. The debt funds in your portfolio can also be 2 in numbers. You can have one sector fund but should not invest if you don’t have enough knowledge of the sector. Depending on their goals whether long-term, medium-term or short term an investor can have 8-10 mutual funds in their portfolio.
What should be done when you have a large number of mutual funds in your portfolio?
The following steps can be taken-
1) Goals for which you had purchased the funds-
There would have been certain goals for which you would have invested in the mutual fund. It could be either for the purchase of a house, child’s education, foreign vacation, car loan, or even your retirement. Check the inflation and how far away you are from the goal.
If you had purchased a mutual fund for a shorter duration you may not be able to sell if the market conditions are not good and you are not making any returns. But if you have purchased for long-term goals you can definitely reduce the number of mutual funds.
2) Check the schemes that have a matching portfolio-
What are large-cap mutual funds? The large-cap mutual funds invest a greater portion of their portfolio in large-cap companies and the portfolio of large-cap funds in India would mostly contain stocks of firms ranked between 1 to 100 in value by market capitalization. Similarly, midcap mutual funds have categorization from 101 to 250 firms based on market capitalization.
Since the large-cap and mid-cap mutual funds category has to invest in companies based on market categorization it is quite possible that the mutual funds have the same stocks in their portfolios. So if you have 3-4 large-cap funds they may have the same stocks and the portfolio may not turn out to be an outperformer. You can reduce the number of such mutual funds in your portfolio.
3) Find out the underperforming funds-
If you have a large number of mutual funds it is always good to weed out the underperforming ones. A fund that was a high performer earlier may have become an underperformer now and it may be a difficult decision. A time frame of at least three years should be there before you remove the underperforming fund. The factors on which the decision can be based are; check for the economic conditions, the returns of a fund as compared to its peers, and also its performance as compared to the benchmark. Redeem funds that have underperformed their peers and the benchmark for three years.
4) Keep funds with low co-relation.
As we have discussed above large-cap funds invest in stocks with top 100 market capitalization. It is wise to sometimes invest in funds having different management styles. You can keep one mutual fund with a growth-oriented portfolio and the other one that follows value investing. These funds would definitely invest in different stocks. Have another fund that invests in international stocks. This way you would be truly diversified across sectors and countries. Not only equities you can have a portfolio that is diversified across gold, fixed deposit, debt instruments, and equity with a proper asset allocation.
5) Consider the tax implications-
Once you have decided to trim your mutual fund holding and bring it to a level where you can monitor the funds comfortably in the portfolio consider the tax implications. Many mutual funds have an exit load when the units are redeemed within a year. The other thing is you will have to pay the capital gains tax. When you sell the equity funds the long-term capital gains will apply (on gains above Rs. 1 lakh) at the rate of 10% when the units are redeemed after 1 year and short-term capital gains will apply at the rate of 15% when the units are sold within 1 year.
Having too many mutual funds in the portfolio does not offer extra benefits and as per the perception of some people, it does not help to lower risks. On the other hand, it increases the burden of monitoring all the funds and takes more effort to manage the portfolio. If you are not able to monitor then the underperforming fund would pull down the returns of the portfolio. The benefits of diversification can be achieved even with a lesser number of funds. Once you have right-sized the portfolio you can review it twice a year. This would help to keep a well-balanced portfolio aligned with your goals and risk appetite.