How many funds should I invest in?

How many funds to invest in is a question that both new investors and the seasoned ones are confronted with. I have seen portfolios with 90-100 funds too! What should be the ideal number of funds that you should hold to avoid duplication and keep your portfolio maintenance easy?

This is the question that we’re addressing in this article.

(This article was first published in July 2020 and is now edited and republished for the benefit of newer subscribers)

There is no one fixed ideal number of funds that we can give you 🙂 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. So let’s go a little more into details.

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.

Alternatively, you could go with a large-cap passive index fund and use a low-risk short duration debt fund too. If you go with passive index funds, then the need to diversify also reduces. For example, you don’t need two Nifty 50 index funds. One should well do. Nor do you need a Nifty 50 and a Sensex index fund. Either should do.

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. Hence, diversifying across AMCs (in debt specifically) becomes important as your corpus becomes large.

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). 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.

Again, this is just a number, not a rule. It could even be just 4-5 funds if you are say building an all-passive or mostly-passive portfolio. Here, the risk of over concentration in a specific AMC won’t apply as long as you choose index funds with low tracking error and the underlying indices are inherently good ones. (you can refer Prime Funds for our passive calls).

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 flexicap, 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. In this regard, using our Mutual fund portfolio overlap tool will help you weed out such overlaps. You can read about how to use this overlap tool here: https://www.primeinvestor.in/how-to-identify-mutual-fund-overlap/

Keep the following points in mind:

• Focus on mixing styles – growth, value, blended growth-and-value, focused, cash holding, or hedging strategy and so on. For example, between 2018-20, quality or concentrated portfolios outperformed. But post 2020, value investing topped. Hence, mixing such style as part of your portfolio would have helped when one strategy did not perform. And remember, a fund can be focused or value even without being in the focused fund category. So go by your fund’s strategy, more than just category. In our Prime funds, you will find the Why this fund link for each fund. Here, we would have specified the strategy followed by each.
• Don’t try to time styles and strategies – When you see a certain strategy or style outperforming, there is a tendency to go overboard with that. For example, many of you may be adding more value funds now as you see them outperforming. Two things can go wrong here: you will 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 simply went with a market-cap based index fund for the equity exposure as we wanted to stick with the market as we did not want any underperformance in a portfolio that was partly for income generation. However, we added more styles in to our high-growth fund to prevent steep falls, given the aggressive equity allocation there.
• Diversification is now possible with pure index funds as well given that you now have funds across large, mid, small and even mix of large & mid. There are also passive debt funds.

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, corporate bonds funds, or even passive target maturity funds, you don’t need to hold multiple schemes in each category. This is because, liquidity related risks are lower in these. Adding too many funds will only leave you 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.  In other words, in a long-term portfolio, your debt should have a mix of short (accrual) and long duration to navigate various phases of the rate cycle.

When you end up adding more funds

In our experience, the biggest reason for investors adding more funds 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 expectation probably is to get you to invest more and it is easier when new ideas are offered than asking you to invest in existing 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 firm) 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.
• You can use our MF portfolio overlap tool to identify duplication in holdings.

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

Here are a list of other basic articles on building/maintaining your MF portfolio:

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