How many funds should I invest in?

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In our earlier set of articles (given below), we have discussed some of the key tenets of portfolio management.

  1. How to invest for the long term
  2. Portfolio rebalancing
  3. How close to your goal you should move out of equity
  4. When you can hold equity even after reaching your goal
  5. How to use SWP as a low-tax income option

While you use the above guidelines to build portfolios, you might be confronted with the question of how many funds you should hold. This is a question that we’re addressing in this article.

How many funds

As is the case with many other questions, there is no straight answer to this question. But what we can tell you for sure is this:

  1. It’s not just the number of funds in your portfolio that is important but the mixing of styles and strategies for each goal that you have. In other words, one goal – one portfolio – sufficient diversification.
  2. Once you build a portfolio focused towards a goal, then mixing styles and therefore keeping number of funds optimal become easy. It is perfectly fine to use same fund for multiple goals.
  3. The style or strategy that needs to be mixed depends on the time frame of your goal.
  4. The quantum of money you plan to invest will decide how many funds you need.
  5. Excessive exposure to a single fund is best avoided in high risk categories that have liquidity, default or high volatility risk. This is specifically true in debt.

You can have these broad guidelines and try to apply them to keep your portfolio in shape, and yet not too concentrated and not too diversified.

How many funds for beginners?

How many funds to hold is not a question that should bother you as a newbie. If you are beginner investor, with say a total of say Rs 5,000-10,000 of SIPs, or less than Rs 50,000 lumpsum you probably don’t need more than 2-4 funds. This is simply because you likely know very little about the fund risk, the fund strategy and how to mix them.

But when I say have just 2 funds, you can’t pick one high-risk equity and one high-risk debt. We have seen first time investors hold one midcap fund and small cap fund or an all-aggressive portfolio. You definitely need to go with index funds or diversified equity funds and a low-risk debt fund. How do you do this?

Let us take our 1-3 year time frame based portfolio. Here, you will see that we did not try to add equity funds directly and instead make do with a hybrid fund, keeping the rest in a mix of low-risk debt. We did 3 things here: one, by having a hybrid fund, we would reduce the number of funds that were needed for asset allocation. Two, we ensured that given the time frame, the portfolio is not hit hard by any equity fall. The hybrid fund we chose is meant to cushion downsides. Three, we diversified debt funds and not equity, as the former has higher AMC-related liquidity risk.

You might ask whether holding 2-3 funds would mean high single fund exposure. Yes, it does. However, what you need to remember is that the quantum of wealth is what determines how much a hit hurts you. A Rs 10,000 lost in a credit risk fund versus Rs 10 lakh lost in the same fund makes a huge difference to your wealth and your psyche – even if, in both the cases, the fund accounts for, say, 20% of the portfolio.

Need more styles not number of funds

As your portfolio grows, you need to add some funds – in our view –in the range of 6 to 12 (if you have more debt, there is a need to add more funds across AMCs). Again, this is just a number, not a rule. Having 6-12 funds, for example, would mean individual funds would be 8-17% of your portfolio – which serves as a good limit. This will also give it leeway to grow to say 20-25%, which can be an outer limit.

When we say 6-12 funds, we mean all your goals put together. You may have same funds across different portfolios.

Adding equity funds should be based on the differentiated investment styles rather than based on just categories. For example, there is no real need to add one large cap, one multi-cap one large & midcap and so on – from each category. You will only end up holding portfolios with 50-70% duplication in stocks. Keep the following points in mind:

  • What is more important than choosing multiple categories, is mixing styles – growth, value, blended growth-and-value, focused, cash holding, or hedging strategy and so on. For example, in the last 2 years when only a narrow set of stocks outperformed, focused/concentrated portfolios did better than diversified ones. Hence, mixing such style as part of your portfolio would have helped. And remember, a fund can be focused even without being in the focused fund category. So go by your fund’s strategy, more than just category.
  • What goes wrong is when you up your exposure to one style, because you see it outperforming and add funds there. For example, as value starts performing now, you will likely be adding 2-3 value-biased funds. Two things go wrong here: you are unnecessarily adding more funds and two, you are tilting your portfolio to one style. When this style goes out of fashion, you will be sitting on a fully underperforming portfolio. This is true of many portfolios that we have seen – some with 3-4 midcap funds or small cap funds; some with 3 banking sector funds (believing it is diversification) and some with 3 international funds or 2 gold funds. This is not just duplication. It also ends up harming your portfolio when market trends turn.
  • Adding different styles does not mean you need one from each style for all goals. For long-term portfolios, mixing styles can become important so that at all points, at least one strategy performs when the other does not.  But this leeway is not available in shorter duration portfolios. For example, in our income and growth portfolio, we would not have added any value-style funds as we know that this style can go through prolonged underperformance before delivering. However, we added it to our high-growth fund to partly counter the aggressive growth strategy there. Similarly, you would find a value-style fund only in our over-7 year time frame based portfolio and not in shorter time frames.
  • Some amount of mixing styles is now possible with index funds as well given the range across value to low volatility to midcap and small cap styles. When your portfolio is predominantly in index funds, you don’t need to hold, say, 2 Nifty funds or Next 50 funds from different fund houses. Just choose one good index fund with low tracking error.
buy hold sell

Debt needs more care

While mixing styles and strategies is easier to implement in equity, it is not so easy in debt. For example, even if you hold a short-term debt portfolio, we would not recommend that you stick with one ultra-short or 1 low duration fund, given the hidden risks that these categories can mask and that situations can change very quickly. Hence, you should have a few additional funds, duplication notwithstanding – just so you can diversify across fund houses. This is the key to lowering liquidity risks in debt.

This approach is more essential for short-term money. When it comes to long-term investment, the rules explained earlier on avoiding duplication will apply depending on what type of fund you have. For example, if you have highly liquid and high credit quality categories such as dynamic bond funds  gilt funds or even corporate bonds funds, you don’t need to hold multiple schemes in each category. This is because, liquidity related risks are lower in these, leaving you only with too many funds with no differentiating performance.

For example, we have seen investors holding 3 or 4 dynamic bond funds for diversification. This doesn’t really help. Instead, mixing this with an accrual fund (from short or medium duration) would be better diversification without duplication.  

When you end up adding more funds

In our experience, the biggest reason for investors adding more funds (I have seen portfolios with 25-60 funds of investors moving their portfolios from banks) is a new fund offer suggested by a bank relationship manager or simply one more better performing fund is suddenly proposed. When you are approached with this offer, you need to ask the following questions.

  • Is the NFO unique in any way? How is it going to complement your existing portfolio? If there is no clear answer or the only answer is that it is managed by an already successful fund manager, you really don’t need that fund.
  • When you are suggested an additional fund, because its performance is looking better, you need to ask your relationship manager to identify – one, whether it means that your current funds are not doing well and if so, should you exit any underperformer in place of the new one. Two, if not, whether adding this fund will complement your portfolio in any way.

Let me give you an example: if you are given a US-based index fund because you do not hold any international diversification, it is a good strategy. But if you are given a top performing multicap fund, your question should be which fund should you be substituting it with or what this fund can do for your portfolio that other funds cannot. Nine out of 10 times, you will not get a proper response for this. Why? Because the idea is to expect you to invest more; not just switch between funds.

When you do plan to invest more for an already existing goal, a good advisor who has built an optimal strategy will try to allocate the money in existing funds – perhaps changing one or adding another to go well with the current or upcoming market condition or for the goal profile.

Why it’s important not to hold too many funds

An unwieldy portfolio can cause the following harm:

  • One, it will not allow you to track your portfolio well and you will be unable to stay on top of performance and strategy of each fund.
  • Two, the diluted state would mean the performance of a few laggards will pull down the winners’ effort and keep your portfolio return mediocre.
  • Three, the duplication would mean your portfolio is tilted towards a style or market cap – for example, excessive large caps or midcaps or value funds and may result in a bulk of your portfolio going down at once, when one of them fall out of favour.
  • Above all, there is a very low chance you will consolidate them later, fearing high tax outgo. I have put in effort to consolidate many a portfolio (no, we don’t do that in our present form) only to realize that the investor does not want to proceed as he/she is reluctant to pay the taxes to exit.

So how many funds should you hold?

If we were to summarise the long article for you in terms of number of funds alone, it would be as follows:

How we help

  • Using our MF review tool can be an easy way to consolidate your portfolio by first removing the laggards.
  • If you want to understand how we mix styles and strategies you should go through the ‘why this combination’ given in our ready-to-use portfolios. It serves a dual purpose – one of giving your portfolios and two, helping you learn how you can build one yourself.
  • Understanding whether fund strategies are different is best achieved by reading few simple paragraphs that we have on ‘Why this fund’ in our Prime funds. In addition, we have detailed portfolios on some our recommended list of funds (and more being added continuously), to help you get a deep dive into fund strategies.

Once you learn these, it gets a lot easier to keep your portfolio compact and also achieve diversification.

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35 thoughts on “How many funds should I invest in?”

  1. Pradheep Padmanathan

    When you count for concentration, do you count across the portfolio or count in the equity/debt category ? One of my fund is 25% of my equity allocation but only 14% of overall portfolio because I have 60-40 equity debt ratio.

    1. Bhavana Acharya

      We mean as a proportion of the investment as a whole. Not as a proportion to the debt allocation alone or equity allocation alone. – thanks, Bhavana

  2. 6 to 12 funds seems really over di-worse-sification. Dont you think 4 funds including ELSS for equity part is already enough diversification ? Each funds hold 30 stocks so we have like 120 stocks in total

    1. Sure, no harm. Most investors cannot deploy 202-5% of their money in single scheme as they find it too risky. If you can tolerate it no issue. But no, 6-12 is not oevr diversification – it is just some duplication. thanks, Vidya

  3. Hello Ms Vidya
    Categorization according to “cap” is different from categorizations according to “strategy”.
    1) Am I correct in understanding this?
    If yes, then can a particular fund fall into two types of funds since the categorization is different?
    When we see prime ratings of your section the sub category under equity consist of “value” and “large cap” in the same list.
    Cant a large cap fund have a value strategy or a focused strategy?
    ABSL frontline equity lies under ‘Large cap” but ABSL focused fund lies under “focused” category. When we check the top 10 holdings, they are same for both except for percentage. So doesn’t ABSL focused become a part of the large cap category also?

    What am I missing

    1. 1. Yes.
      2. A value fund can be a largecap or multicap yes. A largecap can be focused or value.
      3. When a focused is more multicap in nature we classify under multicap. We don’t go by top 10 holdings. We go by total exposure to large, mid small. And we don’t go by latest. We go by avg of last 2 years – only that will tell a consistent mcap exposure/style of a fund.

      thanks
      Vidya

  4. Hi Vidya,
    Thanks for nicely written article.
    You are mentioning while deciding individual portfolio mixing style is more important than choosing multiple categories. My question is, (1) how do we know particular fund style of investment? My understanding is Categories and sub-categories is readily available but style is not. (2) Which style is suitable for which timeframe? For example, you have mentioned we can have value-style fund if your goal is over-7 year.

    1. primeinvestor_psswwp

      Hello sir,

      Unfortunately, it is a bit tricky to understand a fund’s style. You need to look at portfolios and how they have changed. Sometimes, AMCs will have detailed explanations of the strategy they follow in presentations and other literature on their websites. You can use those, or also refer to any fund manager interviews where they talk about funds. For Prime Funds, we describe their strategy in the ‘why this fund’ section.

      There are several styles and giving timeframes for each will be difficult 🙂 But generally speaking, styles which can go through periods of underperformance and then compensate with a good rally or which are volatile require longer timeframes.

      Thanks,
      Bhavana

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